The Two-Way Street of Retiring Early

Here’s a simple way to check on your progress toward retirement.

Take the total amount you have saved up for retirement. Calculate 3% of that (the easy way is to just multiply your total savings by 0.03). Can you live for a year on that resulting number?

So, let’s say you have $600,000 saved up for retirement. You multiply that by 0.03 to get $18,000. Could you live for a year on $18,000? If yes, then you can retire right now. If not, then you shouldn’t make that leap.

This seems simple, but there are a lot of implications to break down, so let’s dig in.

The Importance of 3%

So, why is 3% so important here? The idea is that you can withdraw 3% per year from a well-invested portfolio and essentially never go bankrupt because the average annual returns of that portfolio will be high enough to ensure that bankruptcy never happens.

In an influential 1998 research paper known as the “Trinity study,” researchers found that a person has sufficient savings in assets if 4% of his/her assets are sufficient to cover a year’s expenses. In almost all situations, with suitably diverse investments, a person could withdraw 4% of the initial balance of that investment per year and it would last through one’s retirement (at least 30 years). Later analysis showed that a 3% withdrawal rate (3% of the initial amount) would allow the investments to last essentially forever.

The ‘Too Little to Live On’ Problem

The problem, of course, is that in order to be able to withdraw 3% per year and be able to live on that amount, you need to have a pretty healthy investment balance. Let’s say, for example, that you had $1 million saved up for retirement. Three percent of that is just $30,000 a year to live on. Even at $2 million, that’s just $60,000 a year to live on.

If you assume the 7% average annual rate of return that Warren Buffett predicts going forward, in order to get to $2 million in retirement savings in 30 years, you have to be saving about $20,500 per year for the next 30 years. That’s basically 30 years of maxing out your Roth IRA and contributing enough to your 401(k) to be within throwing distance of the annual contribution limit.

A few caveats.

First, we’re not including Social Security here. Most Americans will start receiving something from Social Security in their sixties, which will purely supplement these numbers. Let’s say you’re wanting to live on $30,000 a year and when Social Security kicks in, it’s contributing $18,000 of that. That means you only need to come up with $12,000 a year at that point.

Second, “retiring early” doesn’t necessarily mean zero income. When I “retire early,” I intend to write a few novels that have been floating in my head for years, ones that, if published, should earn at least a little income. Some people end up wanting to take on a new job of some kind – usually one far less intense than their original one – simply because they miss the camaraderie of the workplace or some of the intellectual challenge.

Third, the real important part here is flexibility. Having a lot of money in retirement doesn’t mean you have to retire at 55. What it means is that you have a lot of options. You could retire early. You could take some career risks. You could switch careers. You could weather a big job loss without much problem at all. When you have a lot of money in retirement, the options are open.

Finally, the Trinity study accounts for interest, so when doing calculations related to it, you don’t have to worry about interest. Just treat everything in today’s dollars and you’re going to be as accurate as you can (because it’s impossible to predict future interest rates).

‘Spend Less Than You Earn’ Revisited

What this all leads me back to is an interesting twist on the standard personal finance rule of “spend less than you earn.”

Let’s say my family is making about $70,000 a year, pretty close to the American average. If we choose to save 10% of our income for retirement, that means we put away $7,000 of our income and we live on $63,000 of it. That’s pretty typical personal finance advice.

Over the course of 30 years, saving $7,000 a year in a typical retirement portfolio that earns a 7% return per year gives us about $690,000 in retirement savings. At the end of those 30 years, we could start withdrawing $20,700 a year from that account and never have to worry about it running dry.

Here’s the problem: Living on $20,700 per year if we’re used to living on $63,000. Yes, even with Social Security, it would still be a significant downgrade in our lifestyle.

Let’s say, instead, that we chose to save 20% of our income. That means we save $14,000 a year and live on $56,000.

Over the course of 30 years, saving $14,000 a year in a typical retirement portfolio that earns a 7% return per year gives us about $1,370,000 in retirement savings. At the end of those 30 years, we could start withdrawing $41,100 a year from that account and never have to worry about it running dry.

At that stage, we’d be dropping from $56,000 a year in living expense to about $41,100, at least until Social Security kicked in.

What if we aimed for 25% instead? At that point, we’d be living on $52,500 a year and saving $17,500 a year. After 30 years, we’d have $1,710,000 saved up, and if we took out 3% per year, that would be about $51,300 a year. That’s almost exactly what we’d need to continue our current standard of living.

So, a quick rule of thumb: If you want to retire in 30 years and maintain your current standard of living, learn to live on 75% of your income and put the other 25% away for retirement.

But what if you want to retire faster? That’s where the two-way street comes in.

Spend Less to Retire Faster!

How hard would you have to cap your spending in order to retire in 20 years with the same standard of living?

Let’s say we sock away 40% of our income. In that $70,000-a-year model, that means we save $28,000 a year and live on $42,000 a year.

In that scenario, in 20 years, we’d have $1,190,000 saved for retirement, and withdrawing 3% of it per year, we could spend $35,700 per year.

It turns out that the magic number to do this in 20 years is a roughly 45% savings rate, or $31,500 per year, while living on about $38,500 per year. If you do that, then after 20 years, you’ll be able to withdraw approximately $38,500 per year from your savings.

If you choose this route, the challenge is to live substantially below your income level. The more careful you are with your money and the lower you can keep your spending, the higher you can push your savings rate without changing your income level.

This is a good path for someone who has a very stable job without a whole lot of opportunity for salary advancement. Many federal jobs fall into this category; this is a good route to follow if you have a government job.

Earn More to Retire Faster!

The other option if you want to retire faster is to accelerate your income without increasing your spending.

Let’s say that, instead of making $70,000 a year, you want to know how much you’d have to make per year in order to be able to withdraw and live on $56,000 per year starting 20 years from now. To do that, you’d need about $1,870,000 in savings. How much do you have to save per year, getting a 7% average annual return along the way, to be able to pull that off?

It turns out that the magic number is $45,000 per year, so if you add that to $56,000, you’d have to make $101,000 a year and save $45,000 of it while living on the rest to be able to make this work.

Putting It Together

Basically, if you want to retire in 30 years and live off of your savings, you need to be able to live off of 75% of your income and save the other 25%.

If you want to retire in 20 years and live off of your savings, you need to be able to live off of 55% of your current income and save the other 45%.

Ten years? If you want to retire in 10 years and live off of your savings, you need to be able to live off of 30% of your current income and save the other 70%.

Again, those numbers aren’t accounting for things like Social Security, nor are they including precise tax calculations. They’re just a rough target for you to shoot for as you’re getting started, with more precise calculations to follow when you’re starting to think about retirement.

As noted throughout this article, there are really two ways to get to that kind of savings rate: spending less or earning more. Most people will likely end up utilizing both strategies to get there.

Six Practical Strategies for Retiring Early and/or Securely

This little thought experiment leads directly to some practical strategies for retiring early and/or making sure your retirement is secure when you do get there.

Strategy #1: Live within your means – if you can’t afford to buy it in cash (outside of a mortgage or student loans), you can’t afford it. If you’re not rapidly paying down debt or contributing significantly to retirement without accumulating more debt, you’re simply not on a path to retire early (likely, you’re not on a path to retire on time, even). The absolute most fundamental thing you need to be doing is to figure out how to have a day to day life you enjoy while being able to rapidly pay down debt and/or contribute significantly to retirement at the same time.

That’s not easy, I know. There are lots of things that people want to spend their money on. Learning how to resist that clarion call of spending is the absolute most foundational step of personal finance – everything else follows from that.

This doesn’t mean “life becomes no fun.” It means that you’re going to need to figure out what the best bang for the buck in your life in terms of fun actually is and really focus on those things.

Strategy #2: When you get an increase in income, don’t increase your spending. This is always a solid personal finance strategy, no matter what your goals are. Whenever you see a bump in pay, don’t use that as justification for more spending. Rather, keep your spending in check and try to use that bump in pay for financially responsible things.

One clever way to do this is to have your pay automatically deposited in one account, then have a certain amount transferred each pay period to another account that you actually live out of. Whenever you get a pay raise, you don’t change the amount you transfer from account to account. We’ll get back to this idea in a minute, but it conveys the core idea of keeping your spending the same even if your income goes up.

Strategy #3: Pay yourself first. The first thing out of your budget each month should be money contributed to your long-term goals. After that, your plan should be to figure out how to make ends meet with what’s left.

This is one of the nice advantages of a 401(k) or similar plan in the workplace. That money is taken directly out of your paycheck – you’re paying yourself first before you pay all of the bills.

Even if you don’t have a 401(k) or other such plan at work, you can still take advantage of paying yourself first … see strategy #6.

Strategy #4: Cut away at the low hanging fruit of your spending (and keep doing so). People don’t get into financial trouble because of the spending that’s really important to them. They get into financial trouble because they spend money on the things that are least important to them. What are the least important things you spend money on? It’s very likely that you can’t even name what that is off the top of your head, so sit down with your credit card bill and choose the five or so most foolish things you spent money on in the last month. Why did you spend that money? It’s likely that you can’t even name a good reason for it.

Cut that spending. Know what it is by studying your credit card bill and then watch yourself for those moments when you’re about to spend on those things and remind yourself not to do so. For me, I find that thinking about those nonsensical spending moments when I’m doing something else and visualizing myself avoiding them makes it much easier to cut out those bad spending choices in the moment.

Strategy #5: Figure out what you can do in your career path to increase income and make that a major focus of your work. Talk to your supervisor. Talk to others in your career path. See what you need to do to increase your income and make that your goal. Treat everything at work as an opportunity to build the skills and the resume elements you need to move up in your career path.

If you’re not sure what to do first, simply schedule a meeting with your supervisor and ask your supervisor directly what you would need to do to be able to earn a pay raise or a promotion of some kind. Come up with a plan together to help you move to the next step in your career, then follow that plan as efficiently as you can.

When it does happen, remember the first strategy: Don’t let your lifestyle inflate with your income. Instead, put that extra income to good long term financial use in your life.

Strategy #6: Automate. The easiest way to manage saving for retirement and ensuring that you don’t overspend is to automate as much of your finances as possible. Automate your retirement contributions by giving to your 401(k) at work and/or to a Roth IRA you’ve set up on your own. Automate payment of as many bills as you possibly can. You can even automate things like setting up an automatic transfer to a prepaid Visa card from which you do all of your “fun” spending.

The goal is to make sure you’re saving for the future and not overspending even when you’re not thinking about it, and setting up lots of automatic bill pay and automatic transfers is a very effective way to do that. Almost all of my personal finances are completely automated; I only check in every once in a while to make sure things are running as planned or to do something like transfer a bit of money out of our emergency fund.

Final Thoughts

Saving for retirement – particularly if you want to retire early – is a two-way street. It’s not just about spending less. It’s not just about earning more. It’s about both. The tools listed here are a great place to start.

Good luck!

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