Retiring early is a goal for many individuals and couples. In fact, the movement toward early retirement in the Millennial Generation has been given its own name. The FIRE concept stands for “Financial Independence, Retire Early”.
There are even categories of the movement. “Lean” FIRE uses extreme frugality to accelerate savings and investment. “Fat” FIRE uses a more normal approach to lifestyle while saving for retirement. “Barista” FIRE is the concept of working a second job, such as at Starbucks, to earn more money which is then saved for retirement.
We have three learning objectives for this post:
- To understand the balance between lifestyle and saving for retirement and how that balance affects the time required to reach your retirement goal
- Estimate the necessary amount of retirement savings needed to support your retirement lifestyle
- Have a grasp on the three biggest financial risks in retirement and how to reduce your exposure to these risks
The balance between lifestyle and saving is a personal choice, but the concept is pretty simple. At a given level of income from employment or owning a business, the amount you can save toward your FIRE goal is what’s left over after you pay the bills. This math means that less travel, eating out, driving a more modest car, etc. all support the goal of early retirement. However, peer pressure and your own level of discipline will determine your success.
Working more hours or a second job will increase income available to save toward your goal. Being more ambitious and seeking advancement in your career should result in more income rather than working a second job. There are a few shortcuts in this process other than winning the lottery (a long shot), inheritance, or developing a business or invention which can be sold for a significant amount.
So how much will you need to save? This is a more complex calculation, especially if you are seeking full retirement in your 40s or 50s. Most reliable retirement income studies are based on a retirement duration of 30 years, so from the traditional retirement age of 60 or 65 to age 90 or so. In these studies, the “safe” withdrawal rate is generally accepted to be 4% on an inflation adjusted basis. A $1 million nest egg would then produce about $40,000 of annual income. Retiring in your 60s would also offer the addition of Social Security benefits. Retiring before your 60s means you’ll need to live off your own investments until reaching Social Security claiming age.
Hanging it up at age 50 means planning for a 40 year + retirement period. This may stress the retirement income calculation and necessitate a lower safe withdrawal rate to make sure you don’t run out of money while you are still alive. Basing your expectations on calculations is better than just guessing at how much you’ll need and then finding out you’ll need to go back to work later in life.
Along the way to your FIRE goal, it is important to control the level of debt you are responsible for. Living on a lower level of income becomes easier if you don’t have a mortgage, large car payments or credit card debt. Paying off student loans while you are working is also important.
Equally important is investing your retirement savings productively, but not taking too much risk. The aforementioned “safe” withdrawal rate is based on a balanced portfolio of stocks and bonds using historical returns including both the good and bad periods for the financial markets. The “safe” withdrawal rate is a lot lower if you are putting your retirement savings in traditional bank savings vehicles like money markets and CDs.
We also need to acknowledge and minimize the risks that can destroy your FIRE plan:
- Inflation Risk
- Sequence of Returns Risk
- Longevity Risk
While inflation has been low for the last few decades, even 2% inflation can double the costs of the goods and services you need over the course of your retirement. Healthcare costs, which you need more of as you get older, tend to rise faster than overall inflation. Failing to factor in an increase in your retirement lifestyle expenses will yield a nasty surprise somewhere down the line. Most financial planning and retirement income software programs allow for inflation to be calculated into the plan, although it is impossible to predict what the rate of inflation will be in the future.
We like to call sequence of returns risk “the unluckiest man or woman syndrome”. It refers to the fact that some people retire with all good intentions and then the random nature of financial markets cause losses early in their retirement. The continued withdrawal of the desired level of income from a reduced capital base may cause the plan to fail. What was originally calculated as a 4% withdrawal rate may turn into an 8% rate if the investment plan took too much risk and will likely prove unsustainable. Examples of this include people who retired in 2000 right before a 50% decline in stock prices from 2000 - 2002. Another example is a retiree in 2007 right before the 2008 - 2009 financial crisis which also caused stock prices to decline over 50%.
Longevity is an unknown variable for most. Absent a health condition we believe it is wise to plan out to age 90 or beyond to avoid running out of money during your lifetime. The life expectancy for an individual at age 65 is 85, meaning that half of 65 year old’s live past age 85. For a 65-year-old couple there is greater than a 50% chance that at least one spouse will live to age 90 or beyond. Continued advances in healthcare will only make life expectancies longer.
At Integra Capital we use a concept called “Time Segmentation” to attempt to account for and address these retirement income risks. Our software technology allows us to assume an inflation rate to account for the rising cost of lifestyle expenses. The calculation also identifies the amount of money that should be invested in safer investments to avoid sequence of returns risk. We also assume long life expectancies, typically age 90 or longer, to address the issue of longevity risk.
Call us today at 941-778-1900 or visit www.integracapitaladvisors.com to schedule a time to learn more about retirement income planning, including an assessment of your ability to retire early.