Roger writes in with an interesting question:
When you talk about “walk away from it all” money, how would you estimate that? I know it would be different for each person, but what elements do you take in mind, and what percentage of savings or what size emergency fund (24 months of living expenses, for example?) would you constitute reaching that point?
Before you even start looking at this, you need to have a very strong bead on your realistic spending over the course of a year. What do you really spend over the course of a year? Do you anticipate something significant changing that in the future? Figure out your real numbers, not the ones you think you spend in your head.
I think this largely depends on how you define “walk away from it all” money. I see three common definitions:
First, enough money so that you can survive a cold career change without skipping a beat. This is the easiest level to achieve. Basically, it means that you are financially secure enough that you could decide to just go back to college and start over with a new career and financially survive all of that.
Second, enough money so that you survive an extended job loss, but are intending to work in some capacity for the rest of your life. In other words, the level of money you need to simply walk away from your job if you’re burnt out and spend three years recharging, but not enough to truly never work again. This is what most people think of when they think of “walk away” money, I believe.
Third, enough money so that you never work again, period.
Let’s look at each case, because they’re vastly different from each other.
“Cold Career Change” Money
This type of situation implies that you’re not walking away from the work force at all, merely changing direction. It may require a period of time for re-education, but for the most part the biggest change will likely be a reduction in salary at first that will recover over time.
Thus, this kind of “walk away” money is best figured in terms of a cash emergency fund. That fund should be able to replace your living expenses (plus 20% or so, in case of significant life changes) over the period of time you need for re-education, plus a small supplement for the first few years of your new career – say, another year’s worth of living expenses.
So, if you’re going to return to school to get your MBA, for example, you should have the two years’ worth of living expenses you’ll need to get through your schooling years, plus another year’s worth to help you with the readjustment to the workplace – three years’ worth.
During such a transition, one is usually covered in terms of health care. Most universities offer some degree of health support and once your studies are complete, you’ll roll onto another job.
So, my thumbnail for this scenario is a year’s worth of living expenses to help with re-entry, plus enough living expenses to cover the time needed to re-educate. The best way to save up for this relatively low amount is probably in cash in a high-yield savings account or in a certificate of deposit.
“Extended Drop-Out” Money
Some people want to walk away from everything for a while – they’re completely burnt out and need some time to recharge or discover their true passions. Such “wilderness years” usually end with an epiphany of some sort and a new direction in life.
Thus, this scenario basically consists of the “cold career change” scenario with an unspecified amount of time tied onto the front end.
This amount will need to be higher if you need to cover your health care costs during the recovery period. If you’ve got a supportive spouse with health care, this isn’t an issue, but if you’re going at this alone, you need to consider your health care situation during that period. Are you covered by COBRA? Do you have another plan available to you? Will you self-insure? Or will you just go off of health care entirely?
Aside from this aspect, though, a good thumbnail for this scenario is a year’s worth of living expenses to help with re-entry, plus enough living expenses to cover the time needed to re-educate and the time you expect to be in the “wilderness.” For many people, this would mean at least five years’ worth of living expenses.
In this scenario, it may be worthwhile, as you’re saving, to put some of it into the stock market in the form of index funds. Since your target is higher, you will likely be saving for a longer period of time, stretching it out into a period where the stock market might help you. Again, once you start to near the point of needing the money, take it out of stocks and put it someplace safer.
“Never Work Again” Money
When you start looking at walking away for good, the game changes yet again. You’ll need to have enough money saved up so that you’re protected from inflation over the long haul but also have enough to live on. The safest way to do this is to buy TIPS – treasury inflation protected securities. These are basically like any other treasury note you might buy – they’re backed by the federal government. The only difference is that they increase in value with the consumer price index – in other words, the value of the TIPS goes up with inflation.
To see how this works, imagine you buy a TIPS for $10,000 this year. It’s got a coupon rate of 4.25% – meaning that each year, it pays out 4.25% of its principal to you. Each year, though, the government adjusts the value of this investment upwards to match the increase in the consumer price index. So, if the consumer price index goes up 3%, the principal on your TIPS goes up to $10,300. Since you’re getting paid 4.25% of the face value of that note, your old payment before the upward adjustment would have been $425 a year. After the adjustment, it’s $437.75 – a little bit of a bump.
This is the safest place to put your money. If you’re willing to swallow more risk, you can balance these with stocks and such, but if you’re intending to never work again, you do want your income to be stable.
How much do I need? Figure up how much you need for living expenses over a year (including paying for your own health insurance), add 25% to that (for an emergency buffer), and then figure up what your taxes would be. Add those three numbers together to see how much you’ll need those TIPS to produce each year. The advantage of being in TIPS is that you don’t have to worry about inflation – it’s covered.
So, let’s say your living expenses are $40,000 and you need another $10,000 for health care coverage for your family. Add another 25% on top of that for a buffer – you’ll need $62,500 a year. With taxes considered, that takes you up to almost exactly $70,000 a year. With the TIPS at 4.25%, you just divide that annual amount by the TIPS rate – giving you a target number of $1.65 million for a very secure long-term situation.
How do I get there? The best way to achieve that number is probably in stocks in an index fund. If you put away $1,000 a month into an index fund returning 8% a year, you’d hit your target number in 33 years – that’s a long way off.
Obviously, you can survive with less if you’re willing to take on risk and also if you’re going to rely on Social Security and Medicare in your senior years, or if you’re going to assume you’re living until you’re 90 and want to have nothing left by then. Both of those allow you to reduce your target number.
But for long-term security, nothing beats TIPS that will work in perpetuity to provide you the inflation-protected living expenses you need forever, plus give you something solid to pass down to your kids.
The Big Lesson
No matter what, it is always beneficial to start socking away money now for any big changes that may come your way in the future. At a bare minimum, it can help you retire earlier – it may also provide you a chance to completely change your life and walk away from a career that isn’t a good fit for you any more.