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More and more people are trying to redefine retirement. Many are young professionals with good income trajectories and excellent savings habits. Their goal is to get Financially Independent and Retire Early, ideally sometime in their forties (the “FIRE” movement). The key question for them is: when will I be ready to make the leap?
It’s not about a number, there’s a lot to Retirement in Austin Texas
Most advice about retirement starts with a number. How much do I need to have to be able to retire? This is not going to work for FIRE candidates. The typical retiree has a 25-30 year planning horizon. The planning horizon of a FIRE retiree is 45 or even 50 years! You are at about the halfway mark of your life and a lot that can happen in the next 45+ years. The uncertainty is too big to plan for everything that could happen with a single number. It would simply have to be too high for most people.
Consider an often used starting point for retirement planning, the 4% rule. Designed for traditional retirement horizons of about 25-30 years, the rule suggests a withdrawal of 4% of your initial portfolio value every year, adjusted for inflation. This rule implies that you need about 25 times your retirement income if you plan for 30 years of retirement. Suppose you plan to spend 80,000 a year, then you need $2MM in savings, according to the rule (MM stands for million). A similar rule for a 45-year horizon would require about $2.5MM in initial savings (the “3.25% rule”); but even this number may not be enough!
Understand the Uncertainty
Suppose you do accumulate the $2.5MM. First, understand that using historical data, we can’t be sure you won’t be running out of money. The reason is that generating income for long periods of time is enhanced by moderate exposure to risky growth investments like stocks. You can’t rely on bonds alone or even annuities to generate enough income for that long particularly with zero or negative interest rates. This is why most studies of retirement income focus on 50/50 or even 60/40 allocations to stocks and bonds. The uncertainty about stock returns, however, can generate a very wide range of outcomes, and the range gets wider the longer the horizon.
Here is how big the uncertainty is over the 45 years for the 3.25% rule we mentioned above. Using historical data, there is slightly less than a 10% probability of running out of money, which is simply a reflection of how the number was calculated. The point here is that there is a nontrivial probability that the strategy won’t work if blindly followed.
At the other end of the spectrum of outcomes, if you start with $2.5MM and consume $80K a year, you have a greater than 90% probability to leave a surplus behind after death. How big is the surplus? Half of the time, you have a portfolio of over $8MM! That’s how wide the uncertainty is, from running out of money to leaving over $8MM behind.
The chart below shows a sample of 25 simulated trajectories, to illustrate the range of uncertainty.
Sample 45-Year Trajectories of Wealth, at a 3.25% Withdrawal
In the figure, the value of the portfolio is normalized to $100 at the start. In two of the 25 cases, the retiree runs out of money (in one case way too early!). In over half the cases, the retiree ends up with 182% of the initial value, or over $4.5MM if he or she started with $2.5MM. In some extreme cases, the amount is over 10 times the initial value!
Change your mindset about retirement, discuss your options with a Financial Advisor in Austin TX
Now consider what might happen if you manage to generate just $20,000 in income every year. At 3.25%, that is equivalent to having over $600K in additional savings. If you can generate that income, say until age 60 or 65, then you could retire with $1.9MM instead of $2.5MM. If things go better than expected along the way, you may not need to do this for long.
Instead of asking “do I have enough to retire?” redefine retirement with this question: “What could I do with my time that can generate income and does not feel like work?” After all, when most people think about early retirement, they have other goals in mind, besides wearing spandex riding a fancy bicycle. They typically want to pursue a passion. Using that passion to generate just enough to pay for health insurance and some basic necessities like rent or real estate taxes is your best risk management strategy. It will also help you live a more satisfying life in retirement.
Adopt a dynamic strategy
As mentioned above, a key reason for the wide range of outcomes is that capital preservation and income over long periods of time are enhanced by an allocation to risky equities. The higher average growth of equities helps your portfolio sustain its purchasing power for longer. However, the growth isn’t guaranteed. What if you experience returns that are less than expected? Low returns, particularly in the first few years of retirement, can derail your plan.
Ease into it
When you think you are ready, ease into it. Work part-time or find a more flexible job; one that feels less like work. Generating some income to cover necessities is your best risk management strategy.
Start conservatively and plan to ratchet-up spending
Another way to manage the risk of spending too much from the portfolio in the initial years is to start conservatively. Try to plan some spending, like expensive vacations or big ticket items a couple of years ahead, and only pull the trigger if portfolio returns are in line with expectations.
Take advantage of low inflation. If you start with $80K a year, keep that constant and don’t adjust for inflation for the first few years, or only do so if returns are in line with expectations. This is a good way to effectively reduce spending by 2% or so a year.
By being flexible the first few years, you can then increase your consumption over time if portfolio returns are in line with expectations or better. If your portfolio is increasing in value as you spend, you may have some room to increase spending.
Pay yourself first
Identify discretionary spending or large ticket purchases and build up savings for those over time. Say you’d like to go on a trip to Europe in a year or two. Build up the required savings over time with monthly installments. Then monitor your performance and change your monthly savings or target date accordingly over time.
Use your savings efficiently
You are likely to rely on a number of sources for income: 401(k) or IRA accounts, taxable accounts, and tax-exempt or Roth accounts, in addition to Social Security. Make sure your withdrawal strategy is optimized to make the most of your savings. Take a look at some of our writing on the subject. The right strategy can substantially extend the longevity of your portfolio.
You get the point. The key principle behind early retirement is to ease into it with an adjustable or dynamic strategy. Find a way to generate income that does not feel like work, and find enough flexibility to be able to reduce risk early on while taking advantage of the high growth potential that can be realized over the long horizon, as we show in the figure above.
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
