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I'm going to walk through the factors that will determine how soon you can retire. What you'll find is that the math behind early retirement is surprisingly simple. However, there are other factors that can come into play, which can help you get to retirement sooner than the math may suggest. And I'm going to hit on those at the end of this video, so make sure you stick around.
Now, when I say retirement, what I really mean is financial independence. That means you have enough money saved that you don't need to continue working for an income. Whether you choose to or not is up to you.
The factors that go into this equation are your income, your expenses, your savings rate, your investments, and then the return that you earn on those investments. Let's explore those a little bit.
I want to start with expenses. Knowing what your actual monthly expenses are is an absolute necessity for retirement. And I don't mean having a rough idea of your expenses, but you need to have a dialed-in number, which includes non-monthly expenses like auto maintenance, home maintenance, gifts around the holidays and birthdays, and so on.
Getting a good handle on your expenses is what can give you confidence about your timeline until retirement. Now, I have another video that walks through how to get your expenses dialed in and how to track it over time. So make sure you check that out.
Your income, of course, also plays into this equation. The more income you have, the more you can save for retirement.
Income can also be a trap to retirement though. If your income increases, but your expenses increase right along with it, this can really hurt your ability to retire.
The reality is most people's income increases over time as they progress in their career. And the typical response to higher income is a higher standard of living.
This creates a problem because your standard of living will be at its peak right before you retire, meaning you have more expenses you need your investments to cover for you. However, you've only been earning this higher income for a short period of time, so you can't get enough money saved to cover your new higher standard of living. Instead, you want the gap between your income and expenses to be widening over time. This brings me to the next factor and what I believe is the most important number to track on your path to retirement, and that's your savings rate.
Savings rate is the percentage of your pre-tax income that you're saving for retirement. So if I was saving $20,000 per year on a pre-tax annual income of $100,000, then my savings rate would be 20%.
This number is the single best indicator for how quickly you're going to be able to retire because it tells you how much of your income you're spending and how much you're saving.
A higher savings rate will get you to retirement sooner compared to a lower savings rate. And when you hear stories of people retiring at some really young age, like in their thirties, it's because they had an insanely high savings rate.
It's obviously easier to have a high savings rate with a high income, but a high income is not a requirement.
The other factor I want to discuss before we look at the numbers is your investment return. Now all else equal, you'll be able to retire sooner if you have higher investment returns.
Does that mean you should YOLO and speculate on options contracts or cryptocurrencies? No, definitely not. You'd have a better chance of significantly delaying your retirement that way.
There's an upper limit to what we should expect to return on our investments. The allocation decision of how much to put in stocks versus bonds versus cash is really important, but otherwise the returns on a diversified portfolio are mostly out of our control.
The average annual real return for the U.S. stock market over the past 100 years, as measured by the S&P 500, was just north of 7% according to data from Nobel prize winning economist Robert Schiller.
Notice that I said real return, which means it's adjusted for inflation. The nominal return, not adjusted for inflation, would actually be over 10%.
I think there are good reasons to expect lower returns in the future, so using a real return estimate for the stock market of say 6% may be more realistic. Of course that's an assumption and the actual return could be lower or higher than that, which could impact when you can retire.
So how much do you actually need saved to consider yourself financially independent?
There's a basic rule of thumb known as the 4% rule, which says you can spend 4% of your investment balance at retirement and then increase that by inflation each year.
So if I had $500,000 saved when I retired, I could spend 4% of that or $20,000 per year. If I had $1 million dollars saved, I could spend $40,000 per year.
I wouldn't base your retirement decision on the 4% rule alone, but it can point us in the right direction. If you spend 4% of your investment balance in retirement, then the amount we need saved is 25 times our annual expenses.
With this rule as a guide, how many years of saving are required before you can retire if you're starting with $0? Well let's use this calculator, which will take our savings rate as an input and tell us how many years it will take to save 25 times our annual expenses.
With a 15% savings rate and a 6% annual return on your investments, and that's after inflation, it would take 38.6 years to have 25 times your annual expenses saved.
That means if you started saving 15% at age 25, then you'd be able to retire a little bit before you turn 64.
What if you were able to get 50% of your pre-tax income saved? A 50% savings rate would hit that magic number in 15.7 years. That means that a 35 year old with $0 saved for retirement would be financially independent before they turn 51.
Now if you actually want to retire early, there are some things you need to consider and plan ahead for.
Number one, you can't rely solely on retirement accounts. You need to have money saved in a taxable brokerage account. The reason is you can't get to retirement accounts without penalties before age 59.5. So you need some accessible funds that can cover you until you hit that age.
Number two, you need to think about health insurance before Medicare kicks in at age 65. If you retire before 65 and you're not a full-time employee, then you're going to need to find a solution for health insurance. That could mean getting a policy through the ACA exchange or using something like a health-sharing plan, but plan to pay more for health insurance in those post-retirement pre-Medicare years than you were paying when you were a full-time employee.
There's a glaring omission in the talk around early retirement, and that's Social Security. Notice in our projections and needing to save 25 times your annual expenses, we haven't touched on Social Security at all.
Social Security is such a big part of the retirement picture that it's really bizarre most of these tools don't even consider it. And to be frank, the reason is it complicates everything. It turns a simple projection based on savings rate into a mess of a spreadsheet with all kinds of assumptions.
The other problem with Social Security and early retirement is that your Social Security payment is based on your highest 35 years of earnings. Well, if you retire early, you may not have 35 years of earnings.
The earlier you stop working, the lower your Social Security payments are going to be.
As a financial planner, I have tools that can help us consider all of these factors together. So let's take a look at how Social Security changes the timeline until retirement.
We're going to look at Oscar Martinez. Oscar is 35 years old. He's making a total household income of $100,000, and he has $0 saved for retirement at this point.
However, he realizes he's starting a little late, so he's saving a good portion of his income. He has a 20% savings rate, and he's putting that all in his 401k.
Oscar puts his numbers into that retirement calculator we looked at, and he's shocked to find out that it's going to take him 33.4 years to have 25 times his annual expenses saved. That means he'll be working until he's 69 years old.
He is obviously not thrilled about this news, so he comes to me to figure out what's going on. I show him that yes, with his 20% savings rate alone, he's just barely going to make it through retirement if he lives to age 100.
However, he's forgetting about a super valuable source of retirement income, which is Social Security. Now Oscar is a smart guy, so he waits to take Social Security until age 70 to maximize his benefit. And with his work history, we're estimating an annual Social Security benefit of around $45,000 in today's dollars at age 70.
So I add that in, and we can see that he will end up with way more money in retirement. And in fact, I can move his retirement age back to 62 years old, and our projections still have him making it.
That's a seven-year difference by considering Social Security, which is huge.
There's one more thing I want to touch on, and that's the impact of a part-time income post-financial independence.
There's all kinds of stories about super savers who retired in their 30s, only to find that they didn't love retirement as much as they thought. Your peers are also working and you have a lot of downtime, so an alternative version of this early retirement is becoming financially independent, but still doing some kind of work that earns an income.
Maybe you just drop your hours significantly, or you switch jobs to do something that you really enjoy. But some kind of income has a big impact, because number one, whatever income you make, you don't have to take out of your investment portfolio.
Number two, these additional working years will add to your eventual Social Security benefit.
Number three, you could qualify for health insurance at that post-financial independence job, which could lower your healthcare costs.
Let's look at an example of the impact a post-financial independence income can have.
Back to Oscar Martinez. In addition to the Social Security we added before, we're going to say that Oscar will work part-time in a semi-retirement. He'll make half of what he's making now, so $50,000, and it's work that he enjoys, so he's going to do it until he turns 65.
We can see with those assumptions in place, Oscar could move to his semi-retirement at age 58, which is four years earlier than with no part-time income.
So Oscar came in thinking he would be working until he's 70, but after considering Social Security and a post-financial independence income, he could actually move into semi-retirement at age 58.
It goes without saying that the retirement decision is a big one, and there are tons of factors to consider that I didn't even touch on today. So make sure you seek professional guidance before making any changes to your financial plan. If you don’t have a fee-only, fiduciary financial planner you’re working with, reach out to us for a free consultation.
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