Today I’m (finally) sharing something that I’ve wanted to write about for a long time, but haven’t tackled because there is no easy formula: how to determine what is “enough” to save for early retirement.
“Enough” is perhaps the centrally important concept to early retirement.
Calculating it with some degree of accuracy is critical for everyone, especially when we’re talking about much longer retirements than most traditional retirement advice is based on. All of us eyeing early retirement fall somewhere on a spectrum: those in a hurry to quit as soon as possible, regardless of whether they’ve truly saved a safe amount, and those (like us) who are inclined to oversave and are at risk of working forever if we don’t force ourselves to take the plunge. (There’s no risk-free option, after all. Either risk saving too little or risk spending all your good years at work.) Those in the former camp probably have a natural tendency to underestimate their enough, while those in the latter likely overestimate. It’s good to know your own probable tendency heading in, so that you can correct for it in the calculation.
— Ms. Our Next Life (@our_nextlife) August 21, 2017
As with all of our posts, I don’t share our actual numbers (here’s why), but starting with someone else’s numbers is the worst way to think about this anyway, because it artificially anchors your own thinking to a set of circumstances that may not apply to you at all. If you’ve read financial independence blogs for more than a post or two, you’ve probably seen numbers in the range of $1,000,000 in investable assets and $40,000 in annual spending multiple times, which makes those numbers feel like the “right” range, when they may, in fact, be totally wrong for you. (Or totally wrong from a future safe withdrawal rate perspective. Remember recency bias.)
If you already have your “enough” number in mind, then consider this post a method of pressure testing your thinking to ensure you have adequate wiggle room built in. And if you’re just starting your planning, this will help you think about the key factors that determine how much you’ll want to save before you pull the plug.
Before we talk “enough,” I can’t not mention the eclipse, and how incredibly lucky we felt to get a blissful and unobstructed 2 minutes of totality. (Which we may or may not have traveled to see.) ;-) We definitely learned that a total solar eclipse is two events: the partial eclipse leading up, which is cool but not life changing, and the time of totality, the enormity of which we were completely unprepared for. Pictures and video will never be able to capture what totality actually looks (or feels) like, and while we were stoked to get this shot of the corona, in real life the sky did not look black, and the light was so much more shimmery and nuanced than the photos show. Aside from the incredible beauty of totality, we were both totally caught off-guard by how much emotion came with the moment. We now completely understand the “totality or nothing” sentiment that eclipse chasers espouse, and hope all of you who didn’t get to experience totality this time around will find a way to experience it in a future event like the eastern North America eclipse in 2024 (we’re eyeing Durango, Mexico for that one), if not sooner elsewhere. Odds are good after this one that we’ll soon count ourselves among the eclipse chasers of the world — a privilege early retirement will allow us!
And now back to “enough.”
“Enough” As a Concept
In these days of nonstop talk of decluttering, downsizing and minimalism, “enough” has taken on a meaning of “not too much.” Which it for sure does mean. But for those inclined to rush the journey to early retirement, it’s worth reminding ourselves that it also means “not too little.” Especially if you’re planning to quit work for good, there’s a lot riding on that number, and it’s essential to your future happiness that you not shrink it down too much, lest you find yourself short on funds at the very time, in your later years, when you’re least able to hustle for more.
Your “enough” should ideally be many things:
- Enough to allow you to live the lifestyle that allows you the greatest stoke and fulfillment
- Enough to minimize future money stress, even in turbulent markets and recessions
- Enough to cover emergencies and unexpected expenses without derailing your plan
- Enough to let you dream big occasionally
- Enough to let you sleep at night
If your “enough” doesn’t check off all of those — say, it has enough to cover your lifestyle, but not enough to sustain a recession or emergency in the early years of your retirement — then it’s probably not actually enough. And conversely, if your “enough” easily checks off everything, and then some, there’s a chance you’re falling into the “one more year syndrome” trap and working longer than you need to.
“Enough” As a Number
Your “enough” number should be based on four main factors:
- Your annual spending, and spending trends over time
- Your contingency plans
- Your income sources
- Your projection method(s)
Determining your annual spending and multiplying it by 25, as the 4 percent safe withdrawal rate says you can, gives you a rough starting estimate. But 25x is a crude metric for a number that needs to account for a range of factors unique to you.
Fortunately, by determining the four main factors in detail, you can arrive at a number that incorporates the nuance your particulars dictate.
1. Determine Annual Spending, and Spending Trends
If you’re reading here, you probably don’t need me to tell you that determining your annual spending is the single most important step in calculating any form of early retirement plan. Or that decreasing what you spend by chopping out mindless purchases will shrink that number, and in turn shrink your big savings target, allowing you to retire faster. That’s all obvious.
But what might not be obvious is that you may not want to spend the same amount every year in retirement, and your spending now may bear little resemblance to what you’d actually spend in an ideal world in retirement.
For example, most bloggers I know who write about early retirement talk about how much more they’ll travel after they quit. Which is great! But: travel isn’t free. And even travel hacking isn’t free. It often falls into that “spend to save fallacy” that tricks us into believing we’re saving money when really we’re spending more. Or they assume they can practice geographical arbitrage by renting out their place while they travel, which is great if it works. But what if the market turns south for an extended time and renters are hard to find? What if the market becomes saturated with airbnbs and you can’t rent your place out? Will you just skip the travel then? Or will you wish you’d boosted your spending estimate a bit more to be less reliant on a set of circumstances out of your control? All of this impacts your spending estimates.
On the stuff front, the things we buy for free time activities is vastly more voluminous than the stuff we buy for work. And when we suddenly have more free time, I don’t know how realistic it is that we will never want to buy things that aid the activities we’ll fill that free time with. If left to our own devices, wouldn’t we actually be likely to want more stuff, because we’ll have more time to spend on hobbies? Even Mr. Money Mustache has a whole bunch of bikes, guitars, tools and other non-free hobby stuff. We’ll have more time to hunt for deals and find things used, sure, but we’ve made sure to account for this tendency in our future spending.
On the question of spending trends, it’s worth thinking about whether level spending throughout your life is realistic. We plan to travel on the cheap in our 40s and 50s, but recognize that we probably won’t be quite as enthused about crappy mattresses in cheap hotels in our 60s, and might even want to take a cruise or two (or fly first class once our miles are exhausted). Or we might get sick of living in a cold house in the mountains and decide we’d rather spend a little more to live at the beach. That’s the thinking behind our two-phase retirement approach, with our leaner early years and our more cushy “traditional retirement.” Our plan is based on lower spending in the first 18 years of retirement, and then roughly doubled spending after age 60, perhaps more if our returns significantly outpace our projections. (Also helpful if we need long-term care, which currently costs multiple times what many early retirees plan to spend each year and is not covered by Medicare.)
In determining your “enough” spending level, ask yourself all of those questions:
- Does your planned spending level allow you to live a life you love even if everything doesn’t go to plan?
- Is your planned spending level realistic given how different life will be?
- Does keeping your spending level equal over time make sense for you?
2. Determine Contingency Plan Philosophy
I have written lots on contingencies and won’t rehash that here, but it’s super important to think through your own contingency philosophy, meaning what you are or aren’t willing to give up to make your retirement stay solvent, should things not go to plan. That could mean thinking through factors like:
Locality-specific natural disaster deductibles — If you live in an area with hurricanes, wildfires, earthquakes or tornadoes, you may have specialized insurance for those events that comes with much higher than normal homeowners insurance deductibles. If you found yourself having to pay a $30,000 deductible one year, could your plan withstand that hit? Or might you want to consider holding an amount equal to your specific deductible in a separate account, above and beyond what you’re saving for retirement?
Sequence of returns risk — What happens if you retire into a recession (as it looks like we might)? Will your plan be able to sustain you if you deplete more of your assets early in your retirement? Will you plan to go back to work before your resume gap gets too long, or will you drastically trim back your spending? In our case, our spending plan can be cut up to 50 percent if necessary, not that that would be especially fun, but we’ll plan to cut our spending by roughly the percentage of the market drop. Fortunately, we have boatloads of travel miles stockpiled and can still travel even if we are in a constrained spending situation.
Big ticket items — What happens if you need to replace a vehicle? Buy new appliances? Make a major home repair? Move to a new place? How will you factor these harder to predict expenditures into your spending plan? In our case, we have a buffer in our magic number that allows for a chunk of big ticket items. If we don’t end up using the allotted amounts in each given timeframe, then we can do fun things like home renovation projects, but if we need to replace a car, we’ll be glad to have that slush fund set aside.
3. Determine Income Sources Over Time
At the recent Lola Retreat, Emma Pattee talked about how she became financially independent with rental income (in her 20s, y’all. Un-freaking-believable). Mrs. Frugalwoods talked about how their financial independence is based on a combo of assets and rental income, paired with some blog and book income. Ours on the other hand is based entirely on our investable assets, even though we also have a single rental property. That was a good reminder for me that FI is not necessarily based on wealth at all, but on passive income. Does your passive income cover your expenses? is the most important question, not How much do you have?
Which means that how much you need is based not just on how much you wish to spend, but on what sources that income comes from, and how much income those sources generate. If your spending target in retirement is $50,000 a year, that could come from $1,250,000 in invested assets (if you trust the 4% rule, or $1.6M with 3%, or somewhere in between) that you sell off a little at a time. It could come from collecting enough rent to to clear $50K after expenses. It could come from dividends alone on $2.5M worth of stocks (assuming an average 2% yield — though I know dividend investors aim for better than that).
Here’s our income source breakdown, which varies over time:
I’ve been pretty blatant in my assertion that more people should build a two-phase plan like ours, as opposed to converting a lot of those tax-deferred funds for use in early retirement, as the Roth ladder allows, to avoid selling out future you who probably needs that money more than younger, industrious you does. But what matters most is that you know where your income is coming from at each stage.
4. Determine Projection Method
The final factor in calculating your “enough,” after you know your spending levels at each phase, how much extra you might wish to set aside for contingencies, and where your income will come from, is to decide which method to use to calculate your projections. The 4%/25x method is the simplest, but we’re big fans of doing more in-depth calculations that factor in various inflation and market returns scenarios. (I know there are lots of spreadsheet fans out there, so I know we’re not alone.)
In the example we’ve shared here before, which uses IMAGINARY NUMBERS, we show the type of projection that our plan is based on. It’s nowhere near as simple as a 4 percent rule calculation, but it takes into account multiple factors like when our rental income kicks in, when we can switch over to tax-deferred accounts (401(k)s that are soon to be converted to IRAs), different withdrawal levels in each phase (more spending in later years), and what we can expect to have at different rates of return. How you factor in inflation is also important, and whether you want to adjust numbers for inflation or adjust your projected rates of return downward to keep things in today’s dollars terms. Inflation has historically tended to be in the 2 to 3 percent range annually, so if you believe that markets will continue to average 8ish percent in the future, you can run your projections at 5 percent (8% minus 3%) to get a sense of what that will do. Again, these are not our real numbers, but in our actual projections, we use a 3%-after-inflation standard to ensure we’re not basing our plans on overly optimistic future returns.
Building out a spreadsheet like this with the formulas baked in is incredibly helpful for testing out different rates of return or different starting amounts. And a more detailed version could account for likely return differences between invested assets and assets held in cash (currently marginal returns), as well as spending differences over time. It was ultimately by building ours and playing around with it that we arrived at our magic “enough” number for phase one, and verified that our 401(k) balances are already above where we need them to be, meaning we should be set for phase two.
How Do You Think About “Enough”?
Anyone struggling to figure out your “enough” number and have specific questions? Anyone feel extra good about yours and want to share your method for calculating it? Anything you think I missed in this breakdown of how to think about it? Other thoughts, comments, questions? Let’s discuss in the comments!
Categories: we've learned