The time required to accumulate enough retirement funds varies widely. How long have we been doing this? Forty?
Jacob Lund Fisker suggests that you might retire in as little as five years. By publishing “Early Retirement Extreme: A Philosophical and Practical Guide to Financial Independence” (often abbreviated as “ERE”) in 2007, Fisker became one of the earliest advocates of the contemporary FIRE movement (financial independence, retire early). Since then, some of its followers have exploited its principles to retire early. The idea has a lot going for it, but it’s still on the periphery since it’s so radical.
Make sure you have a firm grasp of the complicated personal finance ideas underpinning financial freedom before you begin planning for an early retirement.
The Concept of Early Retirement Extreme
Although Fisker has stated that he now regrets adopting the phrase “early retirement extreme,” his ideas still seem radical to the majority of people.
His basic thesis is that the ordinary individual in the industrialized world may retire in a matter of years if they adhere to two simple concepts: reduce their expenditure to increase their savings rate and then invest those savings to generate passive income.
Spend less money and save more
A large percentage of the population considers themselves to be “frugal.” Fisker, though, lives on a far more modest budget of about $7, 000 a year.
He and his wife seldom spend money on eating out and they have a very modest house. In addition, he maintains a home garden to produce part of his own food, crafts some of his own furnishings, and makes good use of free resources like Freecycle.
To save money, Fisker suggests taking advantage of “loss leaders” in food shops and borrowing Kindle books and audiobooks from a digital library instead of buying them online.
None of these ideas are particularly revolutionary, and many students already use them to cut costs. Fisker just recommends maintaining this extreme frugality for a longer period of time.
Living frugally and putting away as much money as you can will help you retire earlier. It addresses the issue from two perspectives: you save less money for retirement and you develop wealth more quickly.
Passive Income Investing
While it’s admirable to put aside cash, the true payoff comes when you put your savings to work for you through investments that allow them to grow or provide passive income. If you have set up your assets such that they provide enough passive income, you can quit your day job and live comfortably.
You have achieved financial independence when you are able to meet your basic needs without having to work a traditional 9–5 job.
I, for one, am involved in the real estate market. I only spend a small percentage of my earnings on living expenses, and the rest goes into savings and investments. For a portion of my funds, I opt to acquire rental properties, which provide me with a steady stream of monthly income. I can quit my day job and take my family on an around-the-world vacation thanks to the rent I collect. (I actually do this, as I am away from the country for ten months out of the year.)
The Math Behind Early Retirement
The idea is straightforward: use your funds to set up a series of automated sources of income that can ultimately replace your salary from your day job. But what do the numbers say? What are the chances of reaching retirement age in the next five to ten years?
The quick answer is “yes,” but only if you have a (very) high savings rate. Having a larger salary is helpful, too. But some basic ideas are required before diving into the numbers of retiring early.
From Savings to Passive Income
When first contemplating retirement, most individuals ask the incorrect question. Whereas they should be asking, “How much passive income do I need in retirement? “, they instead ask, “How much money do I need to retire?” Using that number, you may calculate your retirement savings. Your planned retirement income is the first step.
Many retirees take a yearly distribution from their savings to pay their ongoing costs of living. When deciding on that proportion, they look to something known as a safe withdrawal rate, which fluctuates depending on the expected lifespan of their retirement savings. You may withdraw your retirement funds far more quickly if you retire at 75 and only expect to live another 10–15 years, as opposed to if you retire at 40 and want to live another 50 years.
The “4% rule” recommends withdrawing 4% of your nest fund year after retiring. If you invest in bonds and the stock market and remove 4% annually, your nest egg should last you at least 30 years, based on past results.
You can determine how much money you’ll need to put away for retirement if you know your expected withdrawal rate. A 4% withdrawal rate means you’ll need a nest egg equal to 25 times your desired yearly income in retirement. In other words, you would need a goal nest egg of $1,000,000 if you aimed to withdraw $40,000 a year throughout retirement.
Wrinkles and a Wrinkly Exemplification
It’s important to remember that since we’re discussing early retirement, we may discount Social Security benefits.
There are now two complications. At the outset, those who retire early must ensure that their savings will survive for at least 30 years after they stop working. Michael Kitces, a certified financial adviser, shows that if you withdraw 3.5% annually from your retirement fund, it should last indefinitely.
That means a 3.5% withdrawal rate can be used by early retirees regardless of their age. That’s why it’s recommended to increase your desired retirement income by around 28.6 if you want to have enough money saved up for retirement. That’s $1,142,857 in savings, good for 40 grand a year in retirement.
Second, these withdrawal percentages are based on the assumption that your entire retirement fund is in paper assets (stocks and bonds). Investing in things like rental property can help you bring in a steady stream of money without having to actively work for it.
Moreover, you can use other people’s money to make the purchase. So, if you learn how to invest in real estate, you can game the withdrawal rate.
To continue the illustration, let’s assume you want to retire with an annual income of $40,000 and hope that half of it will come from paper assets and the other half from rental properties. It would need $571,429 in stocks and bonds yielding 3.5 percent in order to provide $20,000 in annual income.
Estimating a rental’s cost requires more guesswork. Let’s pretend you’re able to get an 8% cap rate when investing in real estate, which translates to an annual yield of 8% when paying cash. For a home costing $100,000, it translates to an annual profit of $8,000.
However, rather than paying cash, you want to take out a loan for 80% of the price, or $80,000, at 5% interest for 30 years.
Your original $100,000 investment is now only $20,000. Your annual net income is just $2,846 after housing costs are deducted. To make $20,000 a year in net rental revenue, you would need to purchase about seven of these homes. It’s easy to see how a $140,000 down payment might be reached by purchasing seven of these homes.
This means that in order to achieve your goal of $40,000 in passive income each year, you will need to save a total of $711,429 ($571,429 + $140,000).
How Much Do You Need to Save in 5 Years to Retire?
Let’s imagine you’ve done the math and determined how much of a nest egg you’ll need to retire comfortably. Five years from now, you plan to have accomplished your goal and then abruptly retire.
You decide to put all of your money into an index fund that tracks the S&P 500 for the next five years. To estimate your future returns, we’ll use the S&P 500’s average historical return of about 10% every year from its beginning in the 1920s.
A monthly amount equivalent to the following would need to be saved and invested in order to accumulate the following sums of money within the given time frame of five years:
- $500,000: $6,457 per month
- $1 million: $12,914 per month
- $1.5 million: $19,371 per month
- $2 million: $25,827 per month
- $3 million: $38,741 per month
Extremely early retirement is appealing to the imagination, but it’s just hot air with little substance.
Concepts like lifestyle design that are more subtle and mature contain the true meat of the matter. Discover how to enjoy a rich and rewarding life without breaking the bank. Increase your savings and investment efforts to accumulate wealth and passive income more rapidly.
No matter how much money you’re making, you should find something you enjoy doing. If the median wage increases, so will aspirations for wage growth. There is no such thing as sufficient wealth; rather, individuals always put in more effort on the hedonic treadmill in an endless pursuit of more. Somewhere with more space.
More ostentatious automobiles. Fashion that’s right on trend. The equivalent of a second residence. Increasing numbers of symbols of prosperity and happiness to flaunt before the public.
The FIRE and lifestyle design frameworks, however, encourage a more holistic approach to living. As my savings and investments grow, I will have less of a need to work. It makes me feel like I can do whatever I want during the day.