Time > Money (Part 3 – how to easily calculate when you can retire)

This is the third post in a four part series. You can find the first here and the second here.

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Are you looking forward to retirement? Would you like to spend all of your time as you like rather than just nights, weekends and holidays? What if you could do that sooner than you previously thought? With this series on personal finance and especially with this post with “math” in the title, some readers may feel that the blog has strayed from its more philosophical orientation (“Life is a journey. What are smart ways to travel?”). In the end though I see this series as fundamentally about how we use our time. Getting our financial house in order is simply a way to spend more of our time in this world on what we care about most. So the personal finance I’m advocating is one with a distinctly spiritual dimension – What makes life most worth living? How can we do more of that?

The best thing about having money is not needing to worry about money.

With this series, the last thing I’m advocating is geeking out over financial planning or fixating daily on the ups and downs of your portfolio. I spend only about three hours a year on this, by the way, mostly rebalancing my portfolio and 5-10 purchases of a small number of index funds. In the last post in this series I’ll introduce a few recommend readings, any one of which is enough to see how easy this can be and to get started.

In this post I’ll introduce two of the best retirement calculators out there so you can see the implications of your own financial decisions (and the likely results of adjusting those choices) for your own retirement.

In the last post in this series I ended with the first two steps anyone should take in planning for their retirement: 1) pay off all consumer debt and 2) maintain a fund in cash equivalent accounts equal to 6-12 months of living expenses.

After taking the two steps above, the only thing that determines how many years you need to retire is the proportion of your income that you save and invest. The income level itself doesn’t matter. I know this is counterintuitive so let’s walk through it with an easy example.
To keep things simple, say you spend half your income every year and save and invest half (but this example works regardless of the percentage you choose). Because investments (stocks, bonds, real estate and the like) provide income, after investing this portion of your income for a number of years you reach a point where the investment income is equal to your consumption level (half of employment income in this example). This point is your financial escape velocity – the point at which you can safely retire.
I’ve avoided geeking out with variables and equations but note that there are no numbers here because the size of the income doesn’t matter – both pre and post retirement you have a consumption level of 50% of your income before retirement. With a fixed rate of saving and investment (50% in this example), if your income is high you invest more, but you also consume more. If your income is lower, you invest a lower dollar amount, but you also consume the same lower amount post-retirement.
The math behind retirement planning isn’t particularly complicated but I have even better news – you don’t need to do any math at all because there are fabulous retirement planning calculators all over the internet. For sheer awesome simplicity, you can’t beat the retirement calculator here at Networthify.com. To calculate the number of years you need to retire, there are just five numbers to fill in and you scan skip three of those because only two of them matter: 1) Current savings rate (as a percentage of your income) and 2) your current portfolio value. You can go ahead and change all numbers to your own but only 1) and 2) matter so the result will be the same if you enter only those.

One critical underlying assumption in all retirement planning is that, beyond the 6-12 months of living expenses you keep in cash accounts, you invest the portion of your income that you don’t spend. Retirement calculators almost always assume a mix of stocks and bonds because as long as you weight the portfolio as heavily toward stocks as is prudent for your age, this type of investing is easy and provides great returns. Real estate and other solid investments count as well (and I include the apartment I own in Barcelona, Spain in “Your current portfolio value” when I do my own calculations).

Early retirement and even retirement at a normal age is difficult to impossible if you park your money in Trusty Bob’s Savings and Loan or under your mattress, primarily because instead of growing at a healthy clip, it actually shrinks steadily because of inflation. Even at the relatively low inflation rate of 2-3% typical in the US and other developed countries, the corrosive effect of inflation is huge when compounded over time. For example, at an inflation rate of 2.5% the real value of your money drops 53% over 30 years. (I calculated this just by turning my iPhone sideways and using the scientific version of the calculator – .975 to the 30th power is about .47). So retiring early (or retiring in any time frame with solid financials) virtually requires investing everything beyond 6-12 months of living expenses you keep in cash equivalent accounts. You’ll be better off if you quickly dispense with the common misconception that savings accounts are a “safe” thing to do with your money. Because the real value of your assets is guaranteed to shrink significantly over time in a savings account (and barely grow at all in CDs) these are actually very risky financial choices.

For people who hate math or who just like to keep things as simple as possible, the Networthify calculator I linked to above is all you need. For a long time though, I’ve realized that I think about retirement planning (and lots of things) way more quantitatively than most people. In the context of financial planning, I’m constitutionally incapable of thinking “everything will work out”, which is the sort of answer I typically get when I ask a friend or girlfriend how they plan for their post employment years.

As someone very comfortable with math and personally interested in personal finance, my personal favorite is the calculator here at FireCalc, and if you share my interests I highly recommend that you check it out. (“FIRE” is an acronym tossed around in the early-retirement crowd and it stands for “Financial Independence and Early Retirement.”) By the way, there’s no difference between the underlying math of early retirement and retirement at a more traditional age so whatever your own retirement plans, these calculators are great tools to plan for your post work years.

The cool thing about FireCalc is that it helps understand the underlying reasoning behind retirement planning principles, for example the standard advice that you can safely spend 4% of your net worth every year post retirement (which means that you need assets equal to 25 times your annual spending to retire).

The thing about the future is no one can say with certainty what will happen, so what retirement calculators and advisors typically do is make assumptions based on historical data (about the returns of stocks, bonds and other investments; inflation rates etc.). They then use this data to quantitatively model the likely result of your financial planning decisions (about how much you invest every year, stock-bond mix, number of expected years of post retirement etc.).

This may sound really geeky and esoteric but when you plan your foreign vacation you probably do something similar – you create a model of the likely weather based on historical data. For example, say you live in a northern city like Stockholm or Boston and plan a vacation to the south of Spain for the following January. While no one can say with any certainty what the weather will be like anywhere in the future, we can say with a very high degree of probability that next January will be nice on the Costa del Sol and cold and dark in Scandinavia, and the reason we can say these things is a lot of historical data.

The logic of financial planning is similar – while no one knows with certainty what’s going to happen with stocks, bond yields, inflation etc., we can make really solid predictions about likely outcomes based on a lot of historical data. And with the right mix of intelligent risk-taking and prudence for your age and other circumstances, these predictions normally yield results that fall somewhere on a continuum between very solid and totally kick ass. Financial calculators and advisors generally take a plain vanilla historical averages (2-3% inflation, 7-9% annual investment returns (pre-inflation)) and prudent recommendations like 4% annual withdrawal rate post retirement (but you can adjust these variables as appropriate) and calculate the expected result of these decisions.

What FireCalc does though, in all its geeky splendor, is take your numbers (for years of post-retirement, current portfolio value and consumption rate) and calculates the outcome for every year since 1871 (the period for which the relevant data is available), and gives you the exact probability that you are on solid financial ground based on this data. In the winter vacation planning example, Networthify is like your travel agent saying, “Go to the south of Spain in January. It’s going to be nice!”. FireCalc is like the agent telling you the exact probability (based on about 150 years of historical weather data) that the temperature will fall within an ideal Goldilocks range that you set.

One of the cool side benefits of doing this blog is that I end up learning a lot about new topics I write about. I knew that spending 4% of your assets every year post retirement was the standard safe recommendation but I didn’t understand why (and naturally wondered what this means for me and other members of the early retirement crowd for who retirement could last 40-50 years).

After reading this post by leading early retirement blogger Mr. Money Mustache and the FireCalc page and doing a few samples calculations I understood why and, unlike a lot of conventional retirement advice, I think this one is quite sound. I see an interesting analogy between standard financial and medical advice. I’m not at all saying that the conventional recommendation that you save and invest at least 10% of your income or the standard medical advice that you keep your blood pressure below 140/80 and have a BMI below 25 (that’s halfway between my body and Donald Trump’s) is wrong. People who struggle in these areas would improve their life by aiming for those standards and there’s completely valid reasons that financial advisors and doctors use them. I’m just saying that as someone who cares a lot about both areas of my life (and can count them as strengths), I want to set my own bars a lot higher, and if you share my priorities you may want to set more challenging targets as well.

The standard recommended withdrawal rate of 4% works because that rate would be safe for all or almost all years for which historical data is available. Essentially, the 4% withdrawal rate is based on the safe assumption that you spend income (dividends, capital gains etc.) generated by your investments but mostly avoid consuming the assets themselves (ie, that real, inflation-adjusted net worth stays relatively constant over time).

A fairly conventional mix of stocks and bonds generates about 7% income on average and they subtract 3% from this to get a real, post inflation gain of 4% a year. These numbers are averages though and there is a lot of variation. The specific timing of bull and bear markets post retirement has a huge influence on your own results. For example, someone who retired at the start of the current decade long bull market (in the US market) would have a huge financial tailwind aiding their retirement. On the other hand, someone who retired just before the Great Depression or the 2008 financial crisis or another multi-year downturn would be at a disadvantage.

The reason that most retirement calculators and advisors recommend a 4% withdrawal rate is that it’s safe in the large majority of situations (based on historical data). Based on the FireCalc calculator, the exact probability of 4% annual withdrawal being safe varies depending on the length of retirement. For example, it worked for 100% of past years with a 20 year retirement period, 95% of years with a 30 year retirement and 80% of the time even with a staggering 50 year retirement period (the sort of assumption you need to make if you retire in your 30s or early 40s). Eighty and even 95% may make some people nervous (and personally I advocate risk-taking but never to an imprudent degree), but after reading the analysis on Mr. Money Mustache and FireCalc and looking at the data from sample FireCalc calculations, I’m completely comfortable with 4% for this reason – as the length of your retirement increases, the chance that 4% annual withdrawal won’t work edges up, BUT the younger you are when you retire the more options you have to make adjustments over time, such as trimming your expenses or generating a bit of extra income through part time work or other means.

I think 4% annual withdrawal is safe with the important qualification that you reassess your financial situation every few years and make adjustments as necessary. For example, if the value of your assets dropped significantly because of a stock downturn (or a big unexpected post-retirement expense), you could adjust by cutting back on spending for one or more years and/or generating a bit of income through part time work or the like. For example, doing a bit of reading in preparation for this post and my own calculations in both Networthify and FireCalc confirmed my sense that I can completely retire, but if a stock downturn zaps my portfolio I could make some relatively painless temporary adjustments like limiting travel in developed countries to family visits and flying economy instead of business. It’s completely natural for portfolios to fluctuate in value and it would be erratic and unnecessary to recalculate and readjust spending every year but I think doing it every 5 years or so is wise and makes the prudent 4% withdrawal recommendation even safer. Once your portfolio recovers – and it will – you can return to your previous levels of post-retirement spending.

In the final post in this series, I’ll offer a select list of the very best readings on this topic.

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Part 4, the final post in this series, has been published here

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