If you would like to reach early retirement, it’s worth asking the question, why? I think the best reason for early retirement is so you can continue to give yourself to your passions, without the need to be paid to do it. I’m not a believer in retiring to nothing, but retiring to something of worth and significance to you and others. But let’s assume you’re headed in the right direction and you want to be free of the necessity of paid employment. Here’s the steps to take to plan to get there.
CALCULATE HOW MUCH YEARLY INCOME YOU NEED FOR EARLY RETIREMENT?
The amount you need to live off for early retirement will vary from person to person. It depends on how expensive your tastes are, what location you want to live in, what activities you want to do, etc. If you’ve done a simple budget or tracked your spending you’ll know how much it takes to live off now. Project that forward to retirement. There will be many costs that reduce, maybe the kids will have left home, maybe you can live in a smaller home, perhaps you won’t travel as far in the car. Most retirement calculators assume you will live off 80% of your current costs. That may or may not be the case, particularly if you intend to retire earlier than most. Some costs may well increase if you wanted to do more international travelling or give yourself to other passions. You should though, be able to land at a pretty reasonable amount in today’s dollars. We’ll account for inflation later. For me, I’d calculate that figure generously at $45k if I own a home, more if I need to rent. So you’ve got a figure, what next?
DETERMINE THE CAPITAL AMOUNT REQUIRED TO PRODUCE THIS INCOME PASSIVELY
In the retirement phase you want your expenses to be met by passive income, while also keeping up with inflation. There’s a number of ways you can generate this passive income which we will discuss. If you want to cut to the chase, option 3 and 4 below are the ones I’d recommend, along with owning your own home from option 2. You will need (the amount you need to live off/0.04) or (the amount you need to live off multiplied by 25). That is how much you need to invest in today’s dollars to live off your investment income and keep up with inflation. Here’s the details of how I came to those figures and the passive income options you have.
Option 1: Put your money in a high interest bank account.
This is a bad option, but one many retires do. The problem with this is that money in high interest accounts barely returns better than inflation. If you get a lousy 3%, and that’s generous, to earn your $45000 per year, you would need to have $45000/0.03= $1 500 000 in today’s dollars. The real problem though is that with yearly inflation of 2-3%, the next year you will need $1 545 000 in order to earn the equivalent of $45000 the following year. That is you would need to reinvest every cent you earn, in order to maintain earning the same equivalent dollars. Do you see the problem? This clearly won’t work, so you will slowly reduce your capital year by year, until it is expended. This is fine if you have a short retirement, but if you want to have an early retirement this is a bad idea. You will end up broke, it’s just a matter of time. You need to earn more than inflation. A high interest account won’t do that for you at the moment. So strike that one out if you want to retire early.
Option 2: Invest in housing.
The good thing about housing is that the capital traditionally increases above the rate of inflation. Houses appreciate in value, so you won’t lose money year on year to inflation, in fact you are likely to gain . Your income from rent will also increase with time. So you can buy in today’s dollars and have a home that rises to beat off the impacts of inflation. This is sounding like a better option.
The problem though, if you live in Australia, is the high capital cost of housing and the ever diminishing income returns on investment. According to Core Logic, rental yields have fallen to 3.2% per year for houses in capital cities. Rents are continuing to fall as asset prices increase. This figure is gross yield, not net yield. It doesn’t take into account costs such as insurance, rates, pest inspections, maintenance and property management. Take those into account and you drop down to around 1.7-1.9%. So on a 1.7% return, to earn $45 000 per year, you’ll need $2 647 000 in property if you invested today. If you are a bit slower on the uptake it will likely cost you more. You also have the headache of managing the properties you own.
So property is better than cash as it does appreciate and is a viable option to consider. Capital returns for property have been high and in the earning phase of life may be a great option to build wealth. But in the retirement phase the cash returns are very low and the real money in your assets are not easy to access. My opinion is that once you come into the retirement phase you should aim to own 1 property, the one you live in. Cash in those capital gains from other investment properties if you have them and invest in more liquid assets like shares. Housing though, may be a great option to get you to the amount you need. Just remember to factor in capital gains tax when you sell.
Option 3: Passive Business Income
If you’ve managed to own and grow a business, this is one of the most effective ways to retire early. Many of the early retirees I meet have owned, still own or have sold a business. A good business will grow well beyond inflation and you may find that others can run the business while you benefit from the profits. Simply grow the business to the point where it’s distributions after costs meet your needs. If you have an entrepreneurial streak, this is a great option. A business can also be pretty satisfying. This would be my number 1 option. But not everyone is able to start a business or grow one to this point. If that’s you, then stick with Option 2 and 4.
Option 4: Invest in Shares
Shares over the long term have typically risen much faster than inflation even with the ups and downs. Owning shares is effectively owning a part of good businesses, it’s option 3 for the masses. The important point is to invest long term with a diversified portfolio. The easiest ways to do this is by buying into index funds, managed funds, LIC’s (Listed Investment Company’s) or ETF’s (exchange traded funds). Index funds are low fee managed funds that track a stock market index like the All Ordinaries, so they are as diversified as you can get. Listed investment companies like Argo or Australian Foundation Investment Company, are low fee fund managers that trade as shares on the Australian stock exchange. Similarly ETF’s are managed funds that trade as shares on the stock market. It’s like buying managed funds as shares. Other managed funds try to beat the index, or diversify over shares, property, infrastructure and cash. They provide diversification but often over the long term fail to beat index funds and can come with higher fees. You can of course seek to do your own research and buy a diversified portfolio of shares over time or have a mix of all of the mentioned. Provided you hold onto your investments, they will grow. Typically they will pay you a dividend in the order of 4% of late and the capital over time will also appreciate, hopefully by as much as or more than inflation. So a 7% return over time might be expected, 3% to cover inflation and 4% to live off. So to get our $45000 that will keep up with inflation we would need to invest $45000/0.04= $1 125 000 in today’ dollars, plus owning your own home. That’s less than half of what you would need in housing.
Safe Withdrawal Rate
So presuming you aim to own your own home and your willing in retirement to invest your money in a good safe diversified portfolio, you will need (the amount you need to live off/0.04) or (the amount you need to live multiplied by 25). For me that’s $1 125 000 on top of my home. This amount is sometimes referred to as the safe withdrawal rate. That is, the percentage of your investment in shares that you can safely withdraw, without exhausting your capital in a worse case scenario. Some would argue for 3% or lower, rather than 4% (ie. the amount you need to live off/0.03). See this article for a larger explanation and a defense of this amount by MrMoneyMustache. Depending how conservative you are, you may want more or less, but this is a pretty good figure to work on, especially if you are fine with earning a few dollars on the side if needed.
Now add the cost of your remaining mortgage and that’s how much you need to save in today’s dollars in order to pretty safely retire from paid work for as long as you need without it disappearing with inflation. If you have current assets or savings already, this will reduce this figure. You may also plan in retirement to downsize your home and use the price difference to lessen this figure more.
So we have (the amount you need to live off/0.04 + outstanding mortgage – net assets and savings). There’s the magic number you need to reach.
What if This Seems Impossible?
For those who are looking at this number and thinking that you have no hope of getting there, don’t worry. Many don’t and won’t and are doing fine. Australia has a great pension system that ensure’s anyone who reaches the pension age will be looked after. Any savings you do have coming into retirement is a bonus. You will have a roof over your head and food to eat. Who cares if you slowly drain down what cash you do have. Life is more than money. Don’t sweat it. Invest what you do have, save what you can and you’ll be fine.
However, it may be that this number is more attainable than you think. So let’s move on.
Calculate How Much You Need To Save Each Month and For How Long to Reach Your Figure, Adjusted for Inflation.
To do this you are best to use an online savings/investment calculator. There are plenty to find on the net, some are more sophisticated than others. I’ve made myself a simple excel spreadsheet that you can download, savings and investment calculator spreadsheet. This spreadsheet compounds quarterly, presuming you fully reinvest all your earnings from investment during your working years. Use the spreadsheet and play around with the numbers. This is fun right? Plug in your starting amount and you can adjust how much you save, the inflation rate and the investment return. You’ll see that you are far better off putting your money to work in shares or housing that have better investment returns over time. Given a conservative investment return of 6 or 7% you can see how much you need to be putting aside each month to say retire in 10 year, 15 years or 20 years. Make sure to look at the amount you need in the adjusted for inflation column. You need to hit your magic number in this column, not in real dollars.
On my figures if I save $4000/month it will take me 12 years to reach my number. If I save $3000/month it will take 14.75 years, $2000 per month, 19 years. Plug in your figures and see how you go. Or put in how much you are saving now and see how long it will take you to reach your number? Do you need to save or earn more?
Now you know how much you need to be setting aside each month to retire at a certain age. Now circumstances change and investment returns vary, but this should give you a rough idea of how much you need to save or earn each month. A goal to aim for, whether or not you hit it. You can keep revisiting this site and updating your figures with time.
Save or Earn?
Now you may be on track, or you may need to boost what you are putting aside and investing. There are two ways to be able to put aside enough money each month to retire at the desired time. Either you save more of your income or you earn more income without spending more of it. Increase your savings or increase your income. Hopefully as this site develops you will see more and more ways to both save and earn.
Make a plan based on what you have learned. Determine how much you would like to be saving and work towards it. If you are fairly young this gives you plenty of time to adjust course and set good patterns early. Saving $1500 per month and investing it wisely, even starting at $0, in 30 years you’ll have $1.38 million in today’s dollars or or $2.19 million real dollars. If you are a bit further down the track, you should be able to work out what you need to be putting aside to get to where you want to be. Retiring early may not be the best thing for everyone, but if that’s what you would like to do, this should help you see what you need to do to get there. It’s also just fun playing around with numbers and seeing the possibilities.