Do you nearly have enough money to early retire?

I had a great conversation with a client this week about how she was nearly in a position to early retire.

My client is in her mid-30s and has for a while earned good money.

She has been pretty good with her spending which has meant that between her and her partner, they have been able to pay off their house and build up a decent amount of savings and investments.

We had always talked about the idea of early retirement but more as an ‘earlier than 65 but not that early’ prospect.

But a change in her life had her thinking about what the next stage of her life looks like and we started talking about how close she actually is to not having to work again.

In my experience, people who are close to being work optional don’t realise how close they are and sometimes a little bit of modelling can open up whole new paths they never expected.

So how much do you need to early retire?

The biggest issue with early retirement is working out exactly how much money you need to do so.

This is because there are too many unknown variables to get an exact number.

If you knew:

• exactly how long you were going to live
• what investment markets were going to do
• exactly how much you would spend over your lifetime

You could work it out to the dollar. Sadly though, life doesn’t work this way.

Therefore, most people who work this out for themselves come up with a range.

The lower end of the range reflects how much they think they need as a base. This number anticipates that things might change and you may need to do some work, but it does give you the financial freedom to make choices which better suit your lifestyle.

The higher end of the range reflects an amount that you feel would be more than enough. This would mean that even with a lot of things not going your way, you still wouldn’t have to go back to work.

So how do you work out your range?

If you google this concept, you will come across the FIRE movement. This stands for ‘financial independence retire early’.

In this community, the commonly accepted wisdom is if you have 25 times your annual spending rate, then you have reached financial independence.

A practical example of this is if you spend $100k every year, then if you saved and invested $2.5M, you would be financially independent.

The idea behind this is that you would invest your $2.5M, draw out 4% every year (i.e. $100k) and hopefully your investment returns would keep the portfolio growing with inflation.

The problem with this approach is it simply isn’t true. It’s based on a study done in the early 90s by a financial adviser who analysed markets over a number of different times.

In the study, the author assumed you would only be retired for 30 years and also that you would be willing to completely deplete your capital.

In any event, it’s an interesting starting point and something to consider in coming up with your range.

In working out your range, your ‘FIRE number’ is likely going to be somewhere in the middle.

Understanding your spending rate

One thing to note is that if you do aspire to retire early, you’re going to need to calculate how much you spend in a year and have a disciplined habit of keeping to this.

Most people during their working lives are happy to just spend whatever they earn. Eventually this catches up with them in retirement but many higher earning people can get away with this for a long time.

If you want to retire early however, you’ll need to know how much you spend to work out how much you need to save.

In addition, you need to have a disciplined habit of how to keep to this spending rate as if you do retire early, you can’t just increase your spending rate and expect that your numbers will hold.

Calculating your lower range

In calculating your lower range, you need to consider the following:

• How long do you expect to live?
• How much you expect to receive from your investments and how much are you willing to incorporate inflation?
• How willing are you to return to work at least part-time?

As an example, you may be 45 and expect to live to 90.

Your house is paid off and you don’t anticipate upgrading etc.

You spend about $70k a year but you could bring this down to $50k if required.

You are hopeful for 7% returns on average and want to incorporate 3% inflation.

Based on these really simple figures, your lower rate may be about $1.75M based on 25 times $70k.

You might however even bring this down further by using the $50k living figure which brings it down to $1.25M.

Now if you’re happy to go back to work if need be, you could quit your job the day you hit $1.25M.

This may not be enough to last you the rest of your life but it at least gives you a good cushion to work out what you want to do after a few years (after all, you can always go back to work to top up the money as needed).

Calculating your upper range

Taking the example above, our person may look at their spending rate of $70k each year and anticipate living for another 45 years.

Using this information, they might decide their upper range is $3.15M which is $70,000 each year for 45 years.

This assumes investment returns which keep up with inflation only and given there are likely to be some additional returns, there is a good chance this person could easily live on this amount.

But how could I ever save and invest this much money?

The problem with an early retirement is you have a lot more years you need to fund entirely from your savings. This means you need to save a lot of money.

One thing to note however is that your savings and investments don’t work linearly, they compound.

If you’ve spent the last 10 years building up your savings of $600k, this doesn’t mean in another 10, you’ll have $1.2M. In fact, to reach this amount (assuming a 7% return), you would only need to save for another 6 years.

And if you wanted $1.8M, only another 4 years.

It gets a lot easier to save in the later part of your saving journey if you are properly investing.

What about tax, superannuation access issues, Centrelink aged pension and sequencing risk?

There is a lot more to working out your early retirement number than the above but in practice, even with the best analysis, it’s still a bit of a guess.

The way to solve most of these issues is to be closer to your upper range than your lower range but life is short so you need to work out what you prioritise, lifestyle or certainty.

Is this that different from normal retirement?

The interesting thing about early retirement is it’s almost the exact same as normal retirement, just over a much longer period.

Even when you retire at 65, you still need an understanding of your spending rate, your expected life expectancy, and your expected returns. Having a range to assist decision making can be really helpful

What if you don’t want to retire early?

Most people don’t want to retire early and not only do I think this is normal, for the vast majority of people this is the better option.

Determining your range isn’t just for people who want to retire early however.

You may have spent the earlier part of your life focused on building a career maximising for income.

By hitting your ‘financial freedom number’, suddenly you have the option of pursuing a career for reasons other than money.

This might be a less stressful or more rewarding job. This might even be part-time.

Work is usually a healthy part of your life. But a little bit of passive income can make a big difference to your overall happiness prior to fully retiring.