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Answers to Some Early Retirement Questions, Part II

A couple other questions I received about early retirement were:

• How much does one need to save each year to retire early?
• How did my wife and I know we could live on what we had saved?

These questions cannot be answered definitively as everyone has different standards of living and a level of risk that they are willing to accept in order to retire early or, for that matter, retire at any time. I can only answer these questions as to what I think is appropriate for an early retirement. Others may have a different view.

How much does one need to save each year to retire early?

Answering this question starts with making decisions about your retirement end goal. More specifically, first, how much do you need to accumulate in assets to retire and, second, at what age do you want to retire.

Below I have re-produced a table from an earlier post because I think this table provides what I think is the best answer to this question.

Table reproduced with permission from Phil Demuth co-author of “Yes, You Can Still Retire Comfortably! The Baby-Boom Retirement Crisis and How to Beat It”

To use this table you need to know your current annual salary (or total family gross earned income), your age (for couples use the highest age), and your current total retirement savings (this amount does not include your home equity, but it does include any equity you may have in any property or business that is 100% dedicated to investment). Here are the steps to use the above table:

1. First divide your current retirement savings total by your annual salary to determine your retirement savings “multiple” in relation to your annual income.
2. Once you have this figure, you look down the left-hand “Savings” column to find your savings multiple of your family income.
3. Then look across your savings multiple row until you come to the column that corresponds to your age (or closest to your age). The figure at the intersection is the percentage of your annual income that you need to save each year for retirement.

The above table assumes you do not have an employer paid pension and you can live on about 80% of your current salary.

As an example, let’s assume your family income is $100,000, you and your spouse are 40 years old, and you have $100,000 in total savings dedicated to retirement. Your savings multiple is 1.0 ($100,000 savings/$100,000 income). So you look along the savings row titled “Savings = 1 year’s salary.” Moving to the right along this row, you stop at the column titled “Age 40.” The percentage of your income you should save each year is 12% of your annual salary or $12,000 per year.

You may be thinking, “Well that’s not too bad, that is doable.” However, before you get too excited about retiring early, I need to tell you one more assumption that the above table makes. The figures in the table assume that you will work until age 70. What if you want to retire earlier, let’s say age 60 instead of 70?

If you want to retire at age 60 instead of age 70, before you use the table, you must add 10 years to your current age. So in our previous example, the 40-year old couple that wants to retire at age 60, needs to use the savings rate in the “Age 50” column. This percentage is 34% of your annual salary or $34,000 per year. This savings percentage rate is much higher than most people can imagine. This is why retiring early is so difficult unless you start early. For the average American couple this savings rate means a significantly down-sized lifestyle compared to the way they are currently living.

My wife and I were on a 20-year early retirement plan starting at age 40. We managed to achieve our goal in 16 years, but as I mentioned in our earlier post, we were lucky in some respects. However, for those 16 years, we did live the way that saving 34% of your annual income implies. As I said before, early retirement is possible for most people, but it really has to have the highest priority to be able to see it through to the end goal.

How did we know we could live on what we had saved?

If you have been following this blog, then you know about the 4% rule. If you need $80,000 per year to live, you divide $80,000 by 4% to find out how much you need to have saved to retire and be reasonably sure your money will last 30 years. $80,000 translates into a $2 million nest egg required at your retirement start date. However, you may be a risk taker and think you can live with a “5% rule.” A 5% initial withdrawal rate means you only need to accumulate about $1.6 million. If you think, you will not live another 30 years, this may be OK. However, what if you are wrong and you (or your spouse) lives 40 more years? Personally, I would not want to risk being wrong.

I know this whole discussion puts a big damper on the idea of early retirement. The numbers just seem overwhelming. So let me give you one other thing to think about regarding early retirement before you completely dismiss the idea. This last thought was something I only consciously recognized in the latter years of our 20-year retirement plan.

One of the things that happen when you are saving a large portion of your income is that you learn to live on a lot less money. My wife and I found we were just as happy living on less as we were before we cranked up our savings rate. I think this was due to the fact that my wife and I view money the same way so it was never a real source of contention. Also when you start accumulating a lot of financial assets and eliminate all your debt, you worry less about losing your job. As a result our stress level was greatly reduced.

If you can learn to be happy living on less income, then it becomes easier to reach your retirement goal. Let me explain using the previous example of the 40-year old couple with $100,000 annual income. I will ignore inflation in this example so you will be able to relate to the figures in today’s dollars.

The savings figures in the above table assume you will live on 80% of your current income, in this case $80,000 per year (80% of $100,000). However, if this couple starts saving 34% of their annual income, and pays federal/state income taxes and payroll taxes which could total about another 20% of their income, then this couple is actually living on 46% of their annual income or $46,000 per year.

Applying the 4% rule to this $46,000 figure means they need to accumulate a nest egg of about $1.15 million. This figure is almost half the $2 million figure required to live on $80,000 per year. The lesson I discovered in our latter years before retirement is, for every $4,000 you can learn to live without, knocks $100,000 off the nest egg that is required to retire (this is true regardless of when you retire). For most people reducing living expenses by $4,000 per year is a lot easier than saving another $100,000. In our case, at the end of our working lives, my wife and I were living on less than 40% of our gross income.

Keep in mind, even if you retire early at this lower cost of living, you will still receive something from social security. Also, presumably, you will pay off your home mortgage soon after retirement if not before retirement. So, even if the high savings rate required while working is more frugality than you want in retirement, there are a couple other income streams that will start a few years later after early retirement. Looked at from this vantage point, the idea of retiring early seems a lot less daunting.

I am sure someone reading this post is thinking, “Well you just cannot ignore taxes when you retire, so this is not a true picture of your living costs in retirement.” This is a true statement.

However, this statement leads me to answer a general question I got from a reader. The question was “What was the biggest financial surprise in retirement that I did not expect before retirement?”

I will answer that question in my next post.

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