How Much Is Enough For Early Retirement?
A little while ago Len (from Financial Farmers – go check them out) commented on my post How We Made Our First Million Accidentally. He asked about financial freedom, not having to work, and early retirement. In my reply I talked about maintaining principal, inflation and a bunch of variables. We both had similar goals (although 40 seems a little to soon for me), but had very different capital requirements ($3+ million vs $1.25 million). So I wanted to redo some of my calculations, and was also questioning some of my assumptions.
Needless to say, I jumped straight to Excel and put in a bunch of numbers and created a table. The result was a list of numbers that changed a lot with even the smallest of input tweaks. Eventually I managed to find some bugs, fix some assumptions and come up with a model that I liked. It was never designed to be exact, but seemed to match what I thought the big picture should look like. It also lined up with some online retirement calculators provide.
So I turned that document into a simple early retirement calculator. Feel free to go and have a play, or keep reading to see what I learnt along the way.
What I Learnt
Below are the three main takeaways from the exercise of building my simple early retirement calculator. As for the numbers, if I can have $1,000,000 in income producing investments by the time I am 40 (hopefully realistic), then without too much risk I should be able to retire and live to:
- over 100 with minimal living expenses ($30k in todays dollars)
- not quite 80 with current living expenses ($40k in todays dollars)
- about 60 with comfortable living expenses ($60k in todays dollars)
That first one looks good. The second one (more realistic expenses) is not quite long enough. The third makes me think that I will have to work forever! Needless to say that minimising expenses is key if you are a normal person wanting to retire early.
The first result was a change in how I thought about capital. Initially I had two thoughts or options around how to use your capital:
- Eating into capital, which is how most people view their savings/retirement,
- Maintaining capital and living off the income, which I saw as also growing the capital by inflation (more below).
After this exercise, this has changed into three options:
- Eating into capital
- This is the same as before, you live off both the income and the capital. This requires the lowest capital, but the downside is that you need to guess how long you will live. That guess needs to be very good. If it isn’t you will need some form of pension to support you (or go back to work). This has always seemed too risky for me, although it is a spectrum, so it really depends on the income vs capital requirement split.
- Living off the income
- This is the same as I was intending previously. You live off only the income produced by your investments. For this to work you need to make sure that your capital continues to provide the income you need to live. So you need to keep increasing the capital by inflation (or more). Living off the income requires a much larger initial capital investment to make sure you can not only live, but also increase the capital by inflation over time. I believe that goal is probably close to unachievable by most people. With living expenses of $50k pa, inflation at 2.5% and investment returns at 6.5% you need over $2.5 million to hit that goal. The benefit is that this should be able to keep going indefinitely (at least in theory).
- Maintaining capital
- This is NOT what I was thinking of previously, and is sort of a mishmash of the two. Maintaining capital is where you keep the capital amount the same, but due to inflation it produces relatively less income over time. The benefit here is a substantially lower capital requirement than living off the income. The downside is that you have to work out how to top up your income (or capital) over time to keep up with inflation. The reason I really like this model now (rather than living off the income) is that it fits in perfectly with part time or non-regular work. The wage income required to help keep the income safe from inflation is a lot less than is required to pay all the bills directly. It is also far less than is required to build that nest egg in the first place. For these reasons this model seems to work best for people wishing to retire early, but still do some (hopefully enjoyable) work on the side. This (or possibly Living off the income, if I am lucky) is what I hope to achieve.
Inflation is a strange concept. The idea that something would be worth more just because time has passed seems strange to me. What I learnt here was that over the short term, inflation makes (at least at current levels) very little difference. It has much less impact than simply shopping around to find the best price, or being willing to negotiate.
The reverse is true over the long term. Inflation makes a huge difference over longer timeframes. With inflation at 2.5%, it will take about 28 years for something to double in value (or for the value of your money to halve). So when people are talking about retiring and living for 30 years off $200,000 (admittedly with some pension income) I have to wonder whether they have taken into account that the value of their money will halve over that period of time. The article I linked to doesn’t seem to mention inflation at all. Have they considered inflation? A 50% drop in value seems like a big deal to me, and something large enough (when talking about long time frames) to mention.
Part of the reason this is so important over the long term is that when you graph your capital in these situations, the graph tends to take a sharp drive towards zero at the end. Similar to the graph of paying off a home loan. This means living five extra years is easier to cater for at the start of retirement, but at the end you have no capital to work with. Thankfully Australia does have the age pension should the worst happen.
As I touched on at the end of Inflation, the age you live to off your capital/investments has a large impact on whether you will make it or not. If you retire early, those “extra five years” can turn into an extra ten, twenty, or even thirty extra years. So given the graph slopes so quickly down at the end, you want to make very sure your money will support you. A slight miscalculation at the start can lead to a massive problem at the end. If you can manage to keep money coming in (using whatever method you choose) for a few extra years, it can make a much larger impact than you might think.
Simple Early Retirement Calculator
As I mentioned above, I created some excel documents to help play with the numbers. So I thought I would try and turn them into a webpage. This would allow other people to play with the numbers for themselves. So I did.
If you want to see how your plans stack up, head on over to my simple early retirement calculator. Just remember to let me know how it worked for you! I’m also keen for any feedback about how it can be improved. So feel free to let me know, and I will see if I can implement it.