Your financial planner tells you 3 million based on your pre-retirement income (assuming you spend pretty much everything you earn, and will continue to spend that much in retirement). The financial magazines tell you anywhere from 2-20 million based on averages. Your parents say “1 million dollars”. The word on the street is that you need a lot, and I mean a lot of money to retire. I’m here to demystify this and explain how much you really need to retire, and more specifically, I’m going to show you how easy it is to reduce this magic number.
So to start, lets level set on a financial term known in the personal finance community as the 4% Safe-withdrawl-rate or SWR. I often refer to it as the 4% rule and it’s dead simple. While this is greatly debated, I’m here to explain what SWR means and assure you that 4% is truly safe. The SWR is the maximum rate at which you can spend your retirement savings, such that you don’t run out in your lifetime. Essentially, it assumes this is the amount you can withdraw from your retirement or investment accounts without ever touching the principle. This rate is based on the average index performance (the entire markets across all geographies) from 1930s to 2015, which is about 7-8%. After you remove inflation, of say about 2.5% you are left with 4.5-5.5% to withdraw without ever touching your initial investment. Before you scream at your screen with outrage and examples about market failure, let me assure you this average rate of return includes market fluctuations. In reality, stocks move up and down with loads of volatility, and so too does inflation. However, dividends are relatively stable even through recessions and if you are holding for the long-term you will realize these historical returns (with a proper asset allocation –ie: buy index ETFs, bonds, real estate etc. and never buy individual stocks). For instance, the TSX has moved an odd 20-30% in the last couple years (we were actually in an economic boom). Anyway, further details can be ascertained by reading up on the research, like The Trinity Study (which tracks historical performance and returns on average). Additionally, the trinity study assumes a retiree will:
*never earn any more money through part-time work or self-employment projects (which you likely will – especially if you are retiring as early as I plan to)
*never collect a single dollar from social security or any other pension plan
*never adjust spending to account for economic reality like a huge recession
*never substitute goods to compensate for inflation or price fluctuation (vacation in a closer place one year during an oil price spike, or switch to almond milk in the event of a dairy milk embargo).
*never collect any inheritance from the passing of parents or other family members
*never do what most old people tend to do according to studies – spend less as they age
Anyway, if you examine all of the research and have finally realized that 4% is an extremely conservative figure we can move forward. Using the 4% SWR we can surmise that $500, 000 can easily earn you $25, 000 (plus growth with inflation) in income forever. If we adjust that same formula and work backwards we can determine how much we need to replace our expenses (or in other words not need to work). Your magic number can be determined anytime you’d like by simply using the 25 rule of thumb. It is as it is sounds: multiply your annual expenses by 25. If you are spending $2000/month, or $24, 000 annual then you need $600, 000 in a retirement account to never need to work for money again. In other words $600, 000 will yield you roughly $2000 a month (on average) forever. Your future generations who inherit the trust will also receive that 2000/month + inflation for life. I use $2000 a month because it is about what I spend for 2 people to live comfortably in a 4 bedroom home, eat healthy vegetables, drive our shared car, and really just live our lives comfortably. I’m always working to reduce this in creative ways, without sacrificing my lifestyle in any drastic way. If I’m being completely honest, I assume a 6% SWR rate (because my asset allocation is both ETFs and rental properties, which net me about 25% ROI per year and so 6% assumes insane vacancy rates in a recession or world crisis). You are probably safe to use a 5% SWR if you think there is a potential that you may earn money doing something in your life (even if it is extremely part-time or passive), may inherit any money, or any of the other above points. The 5% SWR changes the rule of thumb figure to 20x your annual expenses, and about 16.5x your annual expenses for 6%.
As promised I will share with you the two levers at your disposal to reduce the number you need to retire:
1) Reduce your spending (the less you need to live on, the less income you need to reproduce, and therefore the less you need to accumulate).
2) Increase the rate of return you can safely withdraw from your retirement portfolio (this is mainly done through proper asset allocation –like how I am using rental properties to drag my average return way up).
The other thing you can do, which is not really a lever, is find additional passive streams of income (see my article on income streaming). If you assume you can earn say 200$/week with a passive income stream, then you just reduced the amount you need to retire on by $340, 000.
I like to think of everything I buy, and every expense in terms of what it would cost me from my retirement magic number. For instance, a $50/month cable bill will cost you about $15, 000 in investment income to support. If I can cut the cable and move to internet streaming or Netflix than I am $15, 000 closer to retirement, thus greatly reducing the time I need to work (sometimes by months at a time). While I love cable, I certainly am not willing to work 3-6 months straight just to earn that $15, 000 (after tax). This methodology can really be helpful in making that decision.
In practice the SWR does actually work and I connect with many ‘internet friends’ that are doing it now. Even in times of recession things are smooth. Worst case scenario you could always have to work in a bad month, or dip into the emergency fund. I recommend leaving aside some money in an emergency fund if things turn for the worst. However, like the research will tell you even in times of recession the average dividend amounts paid tended to be rather consistent. And since you only buy ETF indexes that dispersed across the world you need not worry as the entire world has never experience a true downturn (it is usually sectors or areas). Since you own a tiny piece of almost every stock, everywhere you need not worry. Diversification is your best friend and will return you consistent income for life.
Use the SWR rate to determine how much you will need to retire. At the finger tips of a Financial Freedom Chaser it can be a very powerful tool in reaching financial freedom.
I’ve purposely left out things like Canada Pension Plan (CPP) and Old Age Security (OAS) which will likely supplement your retirement further because it’s safer not to count on it. When you reach age 65 or 67, or whatever it is by the time we get there, it is going be completely gravy. Another option is to count on the CPP or OAS to replace that active, part-time income stream you may have counted on in your calculations to retire earlier.
-Written in 2015