In my first post, I told a story about the Partners in my consulting firm. These people earned lots of money, yet they still worked well into old age. This wasn’t because they enjoyed the work, it was because their spending habits prevented them from retiring.
The majority of people live their lives like this. They believe that life is about working hard and earning as much money as possible. But because you’re working so hard, you deserve to treat yourself. Why shouldn’t you buy the nicest house on the block, the flashiest new car, or regularly eat at nice restaurants?
According to this common perspective, the role of work is earn money, and the role of money is to buy things that make you happy.
I’ll admit, even I held that view for quite a few years. It felt right to treat myself to nice things as a reward for working 80 hour weeks in a claustrophobic office. But I realised that, despite buying things I thought would make me happy, I wasn’t any happier.
Slowly but surely, I changed my perspective on the role that money plays in my life. I realised that money was a tool that I could use to unlock things that were important to me. That is, time to spend with people I care about and the freedom to focus on what fulfils me.
After this realisation, I had a bunch of questions: How do I manage money differently in order to unlock those important things? Will I ever be able to retire early? What sacrifices will I need to make? Am I being crazy?
And I’m sure you have similar questions, so let’s take a look at the very simple mathematics behind early retirement.
How do you afford to live if you’re retired?
As I learned about financial independence, I learned to look at money a different way. Most people consider money to be a tool that’s used to buy things. After all, when you go to the supermarket and purchase groceries, you’re really just trading money for food.
However, there’s another role that money can play: money can make more money.
If we take a look at our savings account, we will find regular deposits called something like ‘interest earned’. This interest is our savings earning more money for us. Unfortunately, we usually earn a few dollars per month, which won’t exactly pay the bills, so we don’t think much about it.
But what if we were able to save enough money so that we could live off the interest earned?
For example, if we could turn the interest earned in the image above from $150 to $5,000 per month then we wouldn’t need a job!
Let’s take a look at how much we would need to live off the interest earned.
Introducing our simple retirement calculation
The formula to calculate how much money we need to retire (also known as our retirement balance) is as follows:
Retirement Balance = Post-Retirement Income / (Investment Return – Inflation)
That’s a little complex; fortunately there’s a couple of ways to simplify this retirement calculation to make it more practical.
Post retirement income refers to the amount of income we need to survive if we didn’t have a job. This should cover all our compulsory expenses, as well as any spending money that we need (e.g. dining out, holidays, etc.). For most of us, this will be similar to (or less than) our current expenses. So let’s use current expenses to estimate this.
Investment return and inflation has been researched by many, many smart people. A seminal study, known as the Trinity Study, found that by investing in stocks and bonds we can safely withdraw 4% of the portfolio per year without running out of money. This 4% figure implies an investment return of ~7% and inflation of ~3%. I’ll go into detail on the Trinity Study in another article.
Therefore, our retirement calculation simplifies to:
Retirement Balance = Current expenses / 0.04
And simplifies even further to:
Retirement Balance = Current expenses x 25
So that’s it! A good rule of thumb is that you need to save approximately 25x your annual expenses to retire early.
But how can we possibly save that much money?
I’ll be honest, when I first realised how much money I needed to retire, I freaked out a bit. It seems completely unrealistic to save 25x annual expenses!
However, after thinking through the problem logically, I accepted that it’s difficult — but maybe not quite as difficult as it first seems. Anyway, nothing good in life comes easy, right?
Plenty of smart people have tackled this problem and found surprisingly simple ways to reduce expenses. Soon I’ll write an article explaining how we can analyze our current expenses, identify waste, and reduce our spending whilst maintaining the important things.
In the meantime, have a read of my article on money and happiness. You may be surprised to find out that many of the things we spend our money on don’t actually make us any happier. And by shifting our spending to the important things (hint: social interactions and relationships), we can actually save more!
How can I test different savings and investments to see what works best for me?
If you’re like me, then you really enjoy the mathematics behind the early retirement calculation. And you probably enjoy testing different scenarios to see how they affect your early retirement plans.
In my next article I will introduce the Ordinary Dollar Early Retirement Calculator and how it can be used to test different retirement scenarios.
In that article we will run through:
- How to calculate your ‘savings rate’
- Estimating your future investment return
- How tax affects your early retirement
- How to account for different expense levels pre-retirement vs post-retirement (e.g. if you want to start travelling once your retire)
Until then, use this simple calculation to give you a broad understanding of how much money you’ll need to retire. And start thinking about how you can reduce your expenses. Let’s get ready for the fun to begin!
All the best,