For the record, I’ve only once asked a girl for her number. It was October 2007 and I was out in Fells Point in Baltimore. Also, for the record, I got the number. However, when I finally texted it a couple weeks later to go out for Halloween, I got no response. Yes, I will acknowledge that it may have been a fake number. Her loss, I suppose, as I’m certain whomever she ended up with could not compare to this (thumbs pointed in).
In 2000, the Clay Mathematics Institute published the seven millennium problems. Problems thought to be so difficult that solving any of the seven garners a $1,000,000 award. The first of the seven problems was solved in 2010. Today, I hope to solve the second: How Do You Find Your Retirement Number?
For Retirement Planning, there are four very simple equations to determine how much a person needs to retire. The ultimate “nestegg” question.
The Two Questions You Need To Ask
To determine which of the four equations applies to you, you need to ask yourself two very important questions:
- Do you, or do you not, want to decrease your asset base during retirement (working toward zero)?
- Will you, or will you not, have any current income (pensions, side work, royalties, rental cash flow, passive income generated outside of your investments)?
Let’s discuss those two questions a bit more in depth.
Question 1: Drawing Down Assets
We’re all familiar with the 4% safe-withdrawal rule. This oft-cited retirement mantra comes from the Trinity Study: if a person withdraws 4% of their nestegg (blended as 75% stocks, 25% bonds) in Year 1 of retirement, and increases that withdrawal by the growth in CPI, then that person would have a very high likelihood of not outliving their assets over a 30-year retirement. Using FireCalc, we can see this to be true:
Starting with a $25 portfolio (75% stocks, 25% bonds) and with $1 (real dollars) yearly withdrawals, only in the most extreme cases would an investor ever hit a zero balance, and that would only come after the 25th year.
This 95% success rate is a high enough to give most retirement planners a firm footing. Draw down 4% each year and call it a day.
The problem though, is when you start talking about 60 or 70 year retirements. If I retire as planned (at age 34), then I could reasonably live another 50 years, and could possibly live another 65 years. So, how does the “4% rule” stand up for these ultra-lengthy retirements?
As you can see, over a 65-year horizon, the frequency that lines fall below $0 increases quite a bit, evidence by a much lower 81% success rate. Not nearly as good, as this essentially means that if you are going to be retiring in your 30s with 25x your yearly expenses saved up, then you’ll run out of money in one out of every five 65-year retirements. Granted, this doesn’t account for any social security, so you’ll probably be fine. But, lest we forget, it was Custer that said the Lakota probably sleep in late during the summer.
More than these pretty pictures, though, is the psychology behind asset drawdown. I simply would go nuts selling shares to fund my lifestyle. Not only does selling shares decrease your productive assets, but you could also have to sell shares at inopportune times. As I argue here, structured and periodic asset drawdowns is the exact opposite of dollar-cost averaging. In drawing down a fixed asset amount, you are selling more shares when prices are low, and selling fewer shares when prices are high. For this largely psychological reason, I would be very uneasy drawing down my assets in retirement. So, to answer question one, “I Will Not Draw Down My Assets.” Rather, I will only use the yield (interest and dividends) that pay out to me. In a sense, I’ll drink the milk, and leave the cow alone.
Question 2: Current Income
For most of us, retirement does not necessarily mean “no more income.” Many (two-thirds, in fact) will choose to hold part-time jobs, “side hustle” or have some type of regular income coming in from “work-lite” activities. Many want to keep working a little bit to stay sharp, maintain social interaction, continue to feel value, or continue to create—all on their own terms, of course. “Income” could also include things like pensions, social security, royalties, AdSense income from a struggling financial independence blog, freelance or consulting work, or what-have-you. In fact, I’m hard-pressed to even envision a scenario where somebody makes zero income outside of only your investment income. You’d have to be an illegal immigrant (No SSN) with no desire to create, no pension, and no desire to ever do another act or service for compensation. I’ll continue writing throughout retirement. Maybe Retire29 will make a bit of money. Also, as I continue forth on my CPA, I would love (read: truly enjoy) to do personal tax consulting and/or preparation during tax season—if for no other reasons than I’m a nosy person who likes getting in people’s business as well as a penchant for screwing one over (legally) on ol’ Uncle Sam. I’m sure I’ll charge a little for this service. The answer to question two, is then: “I will have some current income.”
Note 1: “Income” cannot include income generated from your nestegg. Like interest or dividends.
Note 2: For these purposes, rental property should be viewed as an income source, rather than an investable asset or part of your nestegg. Take your monthly cash flow from your rentals as current income.
The Four Equations
Alright, lotta math goin on there, but it’s really not bad. Em is your monthly retirement expenses. Im is your monthly retirement income. And “yield” is the aggregate yield of your investment portfolio (probably something like the weighted dividend yield).
The top right cell, highlighted, is the way I’m gonna go. If my retirement expenses (which I’ll detail in the next post) are $2,000/mo and I’m actively making $6,000/yr ($500/mo) from writing, part-time wages, Retire29, or whatever else, then I’ll need my portfolio to generate $1,500/mo. If you look at my portfolio, right now it is yielding 3.5% or so. Plugging those into the top-right equation means that I’d need $514,285 of productive, investable assets to retire.
Working the other way around (which might look easier), if I have $514,285 in a portfolio that yields 3.5%, that will give me $18,000/year in income, or $1,500/mo. Add to that the $500 I make on the side, and that covers my $2,000 of monthly expenses.
Also important to note is the disposition of this $514,285 across taxable (ready to go) investments and tax-deferred (IRA, 401ks, etc.) investments. As I explain in length here, only one-fifth of your nestegg needs to be in taxable investments. The rest can be in tax-deferred investments, as those tax-deferred investments can be converted to taxable without taxes or penalties regardless of age.
Why Is This Any Better Than The Rule of Thumb?
I know what you’re thinking. “Eric, this is simply too complicated.” Why can’t I just go with what Mr. Money Mustache says, and just save up 25x my yearly expenses.
I would not argue against that path at all. After all, the highway you choose is far more important than the exit you take. However, the 25x rule of thumb has two major flaws, IMO. One, it is not perfectly suited for very-long-term retirements or personalities that are very loss-averse (like mine) and that will get nervous when selling shares. Two, it entirely omits the real and often very important impact that a little bit of income can have in retirement. If my portfolio is in the S&P 500, yielding 2%, for every $1 I earn during a month of retirement, my portfolio needs to be $600 less. Likewise, I also wanted to reiterate the power that expense reduction can have on early retirement.
For those looking to retire very early, saving a big pile of money is obviously of the utmost importance. However, also very important is the ability to lower expenses to the extent possible without sacrificing happiness. And equally important is the ability to generate cash flow from outside sources, as that greatly decreases the dependence you’ll have on that fore-mentioned big pile of money.
In my next post, we’ll run the numbers on Retire29, putting real expectations of what my retirement nestegg needs to be based on my expense and income projections.
What do you think? Is this all just lunacy?
Thank you for reading, my friend.