Welcome to the “How to master your early retirement lifestyle” article series. This series takes you on a relaxing walk through the key concepts of early retirement and how they relate to the way that you live your life. These articles are meant to be easy to read, yet informative, without the more complex technical ins and outs of our economy. Other blogs do an exceptional job at getting more into the weeds of our economy, the stock market and investments. My goal with this blog series is to explain the essentials of early retirement.
I am a simple person. I like to remove the bullshit that tends to accumulate atop life’s many different issues, choices and dilemmas and instead distill things down to their more basic elements, and the business of giving corporate America the middle finger in my mid-freaking-30s is certainly no exception. Let’s not make retiring early more complex than it needs to be.
We’ll kick this article off the right way by diving into why anyone would want to retire early – but not just early, super early. Think 30s or 40s.
For me, I want to retire young because I want the freedom to choose my own life. No more alarm clock, eight different bosses droning on about mission statements (Office Space reference), the ability to wake up in the morning and decide exactly what I want to do that day. Basically, if you haven’t seen Office Space, watch it – I want to escape that movie. That’s what this one is all about.
In other words: No. More. Job.
For others, retiring early might be a way to spend more time with friends and family. Or to travel and explore our world. And let’s face it, exploration is just easier when you’re younger. Go hunting. Go fishing. Work on your tennis game. Whatever it is, when a job drains 40 hours of your life from your exhausted organic hodge podge of a human skeleton, we simply don’t have nearly as much time or energy as we’d like for things such as…I don’t know, living?
The reason to retire early is simple. We want to have fun, not do work.
But how do we retire early? Ah, this may not be so simple, but allow me the opportunity to get at the heart of what makes early retirement possible.
Ultimately, the ability to retire early comes down to two very simple principles:
- Reduce your expenses, and
- Maximize your savings
But to what point? The goal: have enough money in your savings accounts that, combined with capital gains (or losses) in the market, your savings and investments will continue to grow even after you begin tapping your investments to provide for your living expenses.
Wait, withdrawing our own money to live? Yes. Remember, after retirement, we no longer have a nice little paycheck. Instead, we live off of what we’ve saved. We pay ourselves with the money that we saved over the course of our working years.
What are your expenses? Everything that you spend money on throughout the year. This includes mortgage/rent, cars, computers, cell phones, televisions (and their associated service plans), pets, health care. Basically, any time a dollar leaves your bank account, this is an expense.
What are your savings? For most early retirees, savings refers to their investment portfolio. It could also include bank accounts, CDs, savings bonds, etc.
To retire early in life, the idea is to build enough wealth to sustain us for 50 or more years without earning another dollar of income. But how do early retirees do this?
How sustainable investments are built
While it’s true that some of us simply “strike it rich” with some brilliant new business idea, or inherit millions of dollars, or were in the right place at the right time, the majority of early retirees – including my wife and I – employ a rather simple strategy to build our investments to a point where, even after we retire and stop actively contributing to our stash of cash, our savings will never run out.
The key is to save oodles of money while working with a simple thought in mind: every dollar that I save today will turn into two, or three, or four dollars that I will live off of later.
Our working years are key to success in early retirement because this is the period where wealth is truly built. This is the magical period of growth ahead of our longer-term enjoyment of that growth without the added burden of holding a full time job.
Most [soon-to-be] early retirees believe in a few basic principles:
- Save considerably more than money spent
- Keep expenses to sensible (not minimal!) levels
- Stock market will provide needed growth to enable long term retirement
The essential part of growing sustainable investments is saving money. Every dollar saved helps build a solid foundation on which growth can (and usually will) occur. Certainly, the stock market cannot build something out of nothing – meaning, if your investment portfolio is blank, there will be no foundation to support growth.
Pro tip: It is also a good idea to build enough buffer in your savings to withstand stock market fluctuations (meaning, those periods when the market might be stagnant, or go down). Also, while income earned through odd jobs after retirement is possible, most early retirees consider that the exception rather than the rule. Most of us would rather not work after they retire.
How much money do we need to save?
Ultimately, this is the most important question. How much money do we need available in our investment portfolio at the time of retirement to sustain us for the rest of our lives?
Well, answer this question: How expensive is your lifestyle?
Incoming! Here is where the “Trinity Study” comes into the picture. Three professors of finance at Trinity University conducted a study to determine how much money can be withdrawn (i.e.: spent) from savings during retirement without depleting the savings. The goal was to determine a reasonable rate of withdrawal that can withstand most economic conditions.
In other words, through the ups and downs of our economy, how much money can we spend and still remain reasonably certain that our money will still be there in 30 or 40 (or more) years – adjusted for inflation? They conducted this study by giving a hypothetical retired person (living 100% off of their investments) a set amount to spend every year and proceeded to analyze economic data in 30-year increments beginning in 1925. This person held 50% of their money in stocks (more risky, but more reward) and the other 50% in bonds (less risky, less reward).
This study revealed that the answer is around 4%. This means that according to this study, 4% of your investment portfolio can be withdrawn and spent every year with a high likelihood of never running out of cash – even if you’re retiring at 35 and only have a couple hundred thousand to your name, and a recession hits. This is called your safe withdrawal rate.
A few quick points to consider about the Trinity study:
- The study assumes no changes to lifestyle and expenditures over the course of retirement
- The study also assumes the retiree will never earn a dime of additional income in retirement, including Social Security and/or pensions
- Lastly, the study does not account for natural decreases in spending rates as retirees age
Luckily for us, these assumptions mean that the 4% withdrawal rate stands a better chance at supporting us through retirement because we, as human beings, make adjustments all the time. When recessions hit, we cut back.
For example, the study found several 30-year periods where 4% did not support the retiree throughout retirement because the stock market performed poorly. However, the study assumed that the retiree stubbornly kept spending the exact same amount of money every year and refused to cut back on anything during that period and never earned a dime of additional income through any means.
Additionally, the study ignores the decrease in spending phenomenon as we age, which indicates that we tend to spend less in retirement than we anticipate, especially as we get older. In fact, retirees often do find that their spending post-retirement is quite a bit less than when they worked.
Nevertheless, the Study still tells us a couple of important things: If less than 4% of your investments are withdrawn each year after retirement without a single spending adjustment, historically your chances of never running out of money for the rest of your life have been pretty darn close to 100%. If more than 4% is withdrawn, the chances of keeping your stash decreases with each additional percent withdrawn each year – again, assuming no changes to spending habits.
Again, let’s simplify. Stock market investing is engineered to provide a return on your money over the longer term. Put $10,000 into the market today and it might grow to $10,600 by the end of the year (6% growth). In 10 years, however, that $10,000 might turn into $15,000 or $16,000. Or more.
In general, the longer that money is left in the market, the greater its potential for growth.
For example, over the past 10 years my investment portfolio has enjoyed an 8.2% growth rate. That means on average, all the money that I have in stock has grown by 8.2% every year. Your investment company will keep these growth calculations on-hand for you. I use Vanguard and their online tools make finding these numbers exceptionally easy.
Let’s get back to the question at hand. How much money do I need to save? To answer this, let’s ask this question a different way: how much money can I safely spend?
To make our math simple, assume that I have $800,000 in total investments. Historically, my investments grow at a rate of 8.2% every year. Thus, I probably want to withdraw something less than 8.2% so my investments continue to grow throughout retirement, but I still want enough income to support my desired lifestyle. So, let’s settle on 6% as my safe withdrawal rate. How much money will I get to spend every year if I withdraw 6% from my $800,000 investment portfolio?
Do the math: 800000*.06 = $48,000. This means that I have $48,000 to spend every year and still, on average, grow my investments by an additional 2.2% every year if my growth averages remain the same. At this rate, and assuming no significant economic instability, I could easily retire with $800,000 in investments and spend no more than $48,000 per year and enjoy reasonably good chances of never running out of money.
Keep in mind: the safe withdrawal rate does not necessarily mean that you’ll always make money, year after year. During the Great Recession of 2008, for example, some stocks shed 30 to 40% of their value. It happens. But over time, your rate of withdrawal should be designed to maintain reasonable certainty that your stash will always be there to support you. In general, the closer to 4% you are, the greater the likelihood of long term success.
If this is beginning to sound a little more complex, let’s simplify: It all comes down to your lifestyle, and we will talk more about that in our next post.
In the next part of this article series, we will discuss a couple different ways to think about early retirement and decide exactly how large of an investment portfolio you will need. This is where the rubber meets the road. This is the fun part!