Sarah and I are aiming to retire before the traditional retirement age of 65; in fact, we’re probably hanging up our professional careers when our youngest son moves out in about a decade or so.
When I tell people that, they usually assume that we either must have some sort of financial secret, we’re earning a lot more money than we are or that we live like hermits. None of these things are true.
For starters, besides a couple of exceptional years where we nearly killed ourselves with work, neither Sarah nor I have earned six figures in a year. We’re not exceptional income earners.
We don’t live like hermits, either. In general, if Sarah or I want something, we have it. If you went through our home, you wouldn’t think of it as much different than the typical American home.
So, what’s the story here? How is it possible?
The “trick,” if there is one, is just understanding what you need to do to retire comfortably, and it’s not hard to understand at all. You just need to live on a large portion of what you earn and save the rest. That’s it. Nothing else needs to be done.
It’s really all about the savings rate.
Let’s say a person makes $50,000 a year. If that person manages to pay for all of their expenses in life — taxes, bills, food, fun, everything — with just $45,000 a year, that means they have $5,000 a year to save. That’s a 10% savings rate, since 10% of $50,000 is $5,000.
The larger your savings rate, the faster you’ll reach a point where you can retire without seriously affecting your quality of life.
Here’s how that works. If you keep putting money into a retirement account, and the money in that account is invested sensibly, you’ll eventually reach a point where the money is growing fast enough that you can stop contributing to it and start withdrawing enough each year to live on without the account emptying out before the end of your life.
So, let’s jump back to that savings rate example. If you’re living on $45,000 a year and saving $5,000 a year out of your $50,000 a year income, you simply need to keep saving until you can safely withdraw $45,000 a year from that account without it emptying out before the end of your life. You need $45,000 to live on, after all.
(Yes, you’ll eventually get away with withdrawing less because of Social Security benefits; we’ll get back to that in a bit.)
The question then becomes how much do I need in that account to withdraw $45,000 a year without much risk of emptying that account before the end of my lifetime?
That’s known as the “safe withdrawal rate,” and there are a lot of studies on that topic. Basically, if the money in your retirement account is properly invested, a 3% withdrawal rate is extremely likely to be safe for as long as you’ll possibly live and a 4% withdrawal rate is extremely likely to be safe for 30 years of withdrawal and probably safe for many years beyond that. Sarah and I are looking at a 3.5% withdrawal rate, which means that we can safely withdraw 3.5% of the balance of the account on the day we retire each year for the rest of our lives. If we retire and there’s $1 million in our retirement accounts, we can withdraw $35,000 per year for the rest of our lives with a very high degree of safety.
So, in that example where you need $45,000 a year to live on and you wanted to have a 3.5% safe withdrawal rate, you’d divide $45,000 by 0.035 and get $1.29 million. If you have $1.29 million in your retirement account when you retire and it’s properly invested, you can withdraw $45,000 a year for the rest of your life pretty safely.
There’s a problem, of course. For most people, numbers like $1 million and $1.29 million seem like enormous numbers. How does someone ever save up to that point?
Let’s again go back to our savings rate example. This person makes $50,000 a year, saves $5,000 per year for retirement, and spends $45,000 per year. Thus, they need $45,000 per year to live on, right, and as we noted above, that means you have to save $1.29 million in total.
On the surface, that seems impossible. You’d have to save for 258 years (!) for $5,000 a year to turn into $1.29 million. It’s not happening in your lifetime!
That’s where the magic of investment returns and compound interest comes in.
Invest early, invest often.
If the money you put into a retirement account is invested aggressively, it should net an average annual return of 7% on your money. I base that conclusion on Warren Buffett’s own estimations of the stock market going forward; it’s a number I trust to be not too optimistic, but not too pessimistic, either.
So, you put $5,000 into your account, right? After one year, it grows to $5,350 — a 7% return. Then, the next year, that $5,350 grows by another 7%, to $5,724.50. The next year, that $5,724.50 grows by another 7%, to $6,125.22. You’ll notice that each year, the amount of growth is bigger than the one before it, right? The jump to $5,724.50 from $5,350 is bigger than the jump from $5,000 to $5,350, and each year the jump is bigger and bigger and bigger.
That’s the power of compound interest. If you put money into something that grows in value by a certain percentage year over year, it will grow faster and faster and faster as time goes on.
If you put $5,000 in an account earning a 7% average annual return and wait 30 years, it will be worth $38,061.
It’s that power of compound interest that makes retirement savings possible. If you start saving for retirement early in your career, compound interest does most of the work for you. Sarah and I started saving in our 20s and 30s, and now we’re looking seriously at retiring early.
What if you’re later in your career? Compound interest still definitely helps, but you’re going to have to contribute more to catch up than you would have needed to contribute early on. It’s still doable, but it’s not quite as easy.
So, what does that look like? Assuming that our friend making $50,000 a year puts his $5,000 a year into an account earning a 7% annual rate of return, he should reach his target number of $1.29 million in the account in 43 years.
43 years? Ouch. That seems like a long time. But not all hope is lost; there are a lot of things that can be done to make that number smaller without making major sacrifices.
Remember, it’s all about the savings rate.
It turns out that if our friend here can bump his savings rate to 20%, that number drops to 32 years.
If our friend can bump that savings rate to 30%, that number drops to 25 years.
To put it simply, the higher you can boost your savings rate, the smaller the number of years needed until you can walk away from work.
But how do you boost that savings rate without making your life miserable?
The “frugality” strategy has some big advantages.
Frugality is definitely one strong strategy for improving your savings rate. Take our example of a person making $50,000 a year. That person is currently saving $5,000 a year and spending $45,000 a year, right? Well, if that person can come up with some painless ways to cut their annual spending from $45,000 a year to $40,000 a year, that not only boosts their savings from $5,000 to $10,000 a year, but also reduces their target number from $1.29 million down to $1.14 million.
In other words, frugality both boosts the savings rate and cuts the target number you need to get there.
Cutting your cable and sticking with just streaming services you already have and over-the-air channels would save the average American household $1,300 a year, for example. If our friend just eliminated cable, that’s a quarter of the difference, right there.
Buying store brands versus name-brand equivalents saves our family about $25 a week at the grocery store, adding up to about $1,250 a year.
Making some simple energy improvements to your home, like fixing windows that leak air, adding some insulation and installing energy-efficient light bulbs, can save hundreds a year without any change at all in quality of life. Here’s an enormous list of simple energy-saving steps anyone can do to trim their energy bills without continuous effort.
Just making those simple changes — cutting cable, buying store-brand goods, and making a few energy improvements — gets our target person pretty close to their goal, and it doesn’t involve any major negative lifestyle changes.
The key is to actually put that saved money aside for retirement rather than just spending it on other stuff, so when you commit to a frugal change or make a permanent change to your spending, you should immediately adjust your automatic retirement contributions so that the money is accounted for. You’re still left with the pool of spending money you had before; it’s just that some of your previous bills now have that money put directly into retirement.
“Earning more” is another powerful strategy, too.
Along with frugality, the other major tool people have for improving their savings rate is to simply earn more money, whether it’s an increase in their salary or pay at their current job, switching to a better paying job, adding a second job or launching a business of some kind. All of those paths can result in a significant bump in your income, and that can definitely help improve your savings rate as long as you don’t bump your expenses at the same time.
Let’s say our friend making $50,000 a year, of which he saves $5,000 and spends $45,000, suddenly sees a pay increase to $60,000 a year. He bumps his spending to $48,000 a year, but at the same time increases his savings for retirement to $12,000 a year. He’s suddenly gone from a 10% savings rate to a 20% savings rate and, as noted above, he just shaved 11 years off of the time it’ll take him to reach his goal.
By simply increasing one’s income without similarly increasing one’s spending, you can see a big jump in your savings rate. However, there’s something very important to note here: if you get a raise and then increase your lifestyle spending, you’re actually hurting your retirement savings goal. You’re raising your amount of annual spending, which raises your overall goal, which means that it will take more years of growth for the money you already have saved to get to that goal.
Again, the key here is to put aside most or all of your additional income and continue to live on what you earned before. If you receive a big bump in income, you should match that with a big bump in your retirement savings rate, leaving you living on a similar amount to what you were living on before but with a massive increase in retirement contributions. Remember, your raise is buying you years of freedom, not more forgettable stuff.
A few key questions come to mind.
All of these ideas will likely bring a few questions into your mind, so let’s address a few of the common ones.
What about Social Security? Social Security is a nice financial benefit that will kick in for many Americans in their 60s. Social Security checks will cover a nice percentage of one’s retirement spending. Alone, Social Security isn’t enough to have a robust life, but it can definitely complement other retirement savings to allow you to live a great life in retirement.
I generally do not include Social Security when I’m calculating retirement savings, because, for one, I’m unsure as to what form it will take when I reach Social Security age. There’s also another major issue when it comes to reaching retirement age.
What about medical costs? Right now, I include the cost of buying insurance as part of living expenses when I’m considering a typical American’s case. My wife’s career path includes health care coverage in retirement, which is a blessing for us, and I was using her health care coverage before I switched careers anyway because it was far better than what I previously had. For many people, however, health care in retirement will mean Medicare, the possibility of supplemental insurance, and then the costs of deductibles and other expenses not covered by Medicare.
In general, I assume that Social Security will handle these additional expenses for us and if there is Social Security money left over, it’s a bonus. Not only does this simplify our calculations substantially, but it also reflects the fact that we simply don’t know what form Social Security and medical insurance will have when we reach retirement age. I basically assume that if we’re close to where we need to be with just retirement savings alone, Social Security will make up the difference while also covering the medical costs.
This perspective does make saving for retirement seem harder than it probably needs to be, but on the other hand, it’s better to save too much than not enough.
What about inflation? Inflation is baked into all of these numbers assuming that your workplace gives out cost of living raises. If inflation is at 2% and your workplace gives you a 2% raise and you maintain your savings rate, everything remains just as it was, basically. Your target number goes up a little (2%), but so does the actual amount you’re putting into the account each year (2%). The end result is a microscopic difference, not enough to really change the math very much. Again, the key is to not spend raises and to stick with your savings rate.
Retirement, particularly early retirement, is about buying freedom. Start now.
I don’t look at retirement as a period where I’ll be doing nothing. I don’t look at it as a period of failing health and loneliness. Rather, I look at it as freedom — freedom from the requirement of having to exchange my time and energy for money. I can do whatever I want with all of my time, and that freedom cannot possibly come soon enough. It is that freedom that motivates me to save as much as I can for retirement, giving up a few of the affluent perks I could have. Our television doesn’t have cable and our cupboards are full of store brands, but Sarah and I will have freedom from having to work for money far earlier than our parents.
What can you do to get there? Start now. Put aside as much as you reasonably can for retirement right away, then look for reasonable ways to cut your spending without reducing the quality of life and also seek ways to earn more without adding misery to your life. The more you sock away earlier in your life, the faster you’ll hit your number and you’ll have that freedom, too.
The path might be a long path, but it’s an easy path. Just bump up your retirement savings rate every chance you get, and you’ll get there.