One of the things I worry about for extreme early financial independence retirees is that they play the numbers too close.
In other words, I think some would be in trouble if something unexpected and costly pops up. And as we know, we should expect the unexpected when it comes to money emergencies.
For example, let’s say a 30-year-old has $1 million saved. Using the 4% rule, they should be able to take out $40k each year and be reasonably sure their money will last. Let’s also assume that $40k is just what they need to make their budget work.
This sort of set-up is considered very normal for many in the early retirement community, but it has a couple inherent risks.
Potential Money Problems in Early Retirement
There are the problems that could pop up given this scenario:
- The 4% “rule” is not a “rule” in the same way a “law” is a “law” in science. A law has been proven to be true. The 4% rule has been “proven” to the extent that it’s been back-tested but as we all know, “past performance is no guarantee of future results.” So basing your entire life on something that is probably true but may not actually happen in your lifetime is risky.
- Their savings withdrawal and expenses match. So if a big expense pops out of nowhere, like let’s say your furnace stops working when it’s zero degrees outside, life starts to get very tough.
What these people lack is something I always try to bake into any of my financial plans: a margin of safety.
Margin of Safety Options
I’m a fairly conservative money manager and thus prefer several, significant margins of safety.
You never know what could hit and how severe it will be, so I think it’s best to have lots of plans/safety/”insurance” in case circumstances conspire against me.
Here’s a list of the margins of safety we have in early retirement:
- Not having to withdraw from assets. I think I’ve been clear about the fact that we are living on the income generated by our assets, not actually spending the assets themselves. So if I wanted/needed, I could take an additional $120k in assets each year (using the 4% rule) to supplement our income. That’s a pretty good cushion.
- Relying on a portion of my assets. Our current income is actually generated by half of our assets. So, in theory, we could spend the other half and not reduce our lifestyle. Big cushion here too.
- Multiple streams of income. I have one really strong income stream (rental properties), a few couple ones (P2P lending and dividends), and one decent and growing (blog income). The last one has the potential to be really significant. Eventually it may be able to rival the rental properties to give me yet another strong margin of safety.
- Large cash cushion. We currently have about two years’ living expenses in cash — and it’s growing. There are actually two reasons for so much cash: 1) provide a margin of safety, of course and 2) be ready for the next real estate downturn. š I would like to buy a few more places if the prices are right.
- Cut spending. Our current annual budget is $85k. As you might imagine, that affords us a pretty high standard of living, especially since we are no longer saving and have no debt. We could cut $30k or so from the budget if worse came to worse.
- Downsize house. Our current home is awesome: 5 bedrooms, 4 1/2 baths, 3,500 square feet, etc. It has plenty of room for us and frequent visitors, which we get often since we live in the AWESOME state of Colorado. It’s in a great location too, near our gym, grocery store, and a handful of shops (we walk to all these places). If we had to, we could sell it and pay rent for roughly 25 years from the house’s proceeds alone (assuming the proceeds didn’t grow one penny). When you factor in the lower costs (maintenance, taxes, etc.) of living in an apartment that gives us even more margin.
- Going back to work. I hate to think about it, but I have very marketable skills, good connections, and could go back to work if I needed. Of course, I could send my wife to work instead, which would be my preferred first response during a crisis. š
- New ways to earn. If I had to, I could implement several money-making ideas I have been tossing around.
- Social Security. I spent my life planning for retirement without Social Security and I’m not really counting on it now. But odds are, I’ll get something. That’s 15 years down the road, but is at least a minor margin of safety.
- Sell stuff. We have tried to keep our “stuff” to a minimum, but if we had to we could sell some items (including a car or two) and likely raise a good amount of money.
I realize having so many margins of safety could be considered a bit over-the-top, but I like having options and flexibility. Perhaps as time goes on, we’ll loosen up a bit and spend, eliminate, or reduce some of them, but for now I’m happy to have lots of choices. To me it’s a key part of early retirement and certainly helps me sleep better at night.
How about you? Do you have any margins of safety built in to your finances?
FYI, for an update on this topic (several years later), see Margin of Safety Update.
We’re looking at employing everything in your list in retirement except going back to work. As such by my math my number will be around the 2-3 percent range all said and done. I’m retiring based on a date not a number, but three percent is the conservative upper end I expect when the date arrives.
I believe your margin of safety is prudent and the reason I want to continue to work for the next 5 years. I probably could retire right now but my margin of safety would be an existance instead of a living. Over the next 5 years I want to replace some things so when going into retirement I am not settling for what I have but will have what I want.
Congrats on having built such an impressive portfolio! I, too, like the idea of having margins of safety. I think that’s why I’m not really in the FIRE camp. As much as the idea appeals to me – I’d rather continue working at my job with no debt and a huge nest egg with income streams. Just having the option to walk out at any time will be enough for me. When my entire salary becomes “extra” we will have truly hit The Big Time!
Not in any particular order.
1) maintain large cash cushion
2) ability to tap into home equity
3) financial plan extends beyond actual anticipated lifespan
4) targeting available cash flows of more than 50% above anticipated spending
I also include certain large expenditures in my financial plan. To the extent that they are not spent in any given year, they are shuffled off into a “slush fund” to be used as needed (e.g., plan for $5k of home repairs/maintenance per year; if current year nothing is spent, that $5k gets put into a dedicated account to be tapped later).
I do that as well with the large expenditures (i.e. travel).
āOf course I could send my wife to work instead, which would be my preferred first response during a crisisā
Based on all the other factors, this seems very unlikely but if it was needed, is your wife in agreement?
Hasnāt it been awhile since your wife has worked? Not that she would need to go back to her prior profession but ādegree inflationā is alive and well especially in health care careers. Donāt entry level audiologists need a doctorate now?
That idea would not go over very well at my house. I would be delivering pizzas before my wife tried to update her now outdated degree.
It was meant mostly as a joke. That’s why I put a smiley face after it.
If one of us had to go back to work, it would make sense for it to be me since I could earn in a week what she’d be lucky to earn in a month.
But if I could not find work (or couldn’t work for some reason) and we really needed the money, I have no doubt she’d work wherever she could find it to help us out (she’s that kind of “do whatever it takes” person.)
Over the next few years, I’m looking to build multiple income streams. Right now I have 3, and am working on 2 more.
I have my day job, my rental income, and a side consulting gig that brings in about 100k a year. I’m looking to build my blog and business into additional income streams that will hopefully exceed my day job income.
In retirement, having cash + income will be my goal.
Thanks for sharing ESI
Oh, for the Oxford comma. š
$100k in “side income” is pretty sweet!!!
I believe that most people chasing an early retirement with a relatively small portfolio inherently know that they’re walking a fine line. However, most want out of the rat race so badly that they’re willing to accept far more risk than they otherwise would.
This is a very good reminder that if something is worth doing, then it’s worth doing right. Make sure you’ve got some safety nets in place.
How about retirement accounts? You can’t access these funds until retirement age and most savers should have a decent sum.
You actually can access them, but it’s a hassle (at least to me). Details:
http://www.investopedia.com/articles/retirement/02/112602.asp
Heh…posted yours while writing mine. š
You did a better job of spelling out details… š
Not quite true.
1) For a 401(k), if you leave the employer’s service subsequent to age 55, you can withdraw penalty free (search for ‘”separation from service” exception’).
2) For IRAs, you can use a Code Section 72(t)(2) distribution for substantially equal periodic payments to get a distribution penalty free. See here: https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-substantially-equal-periodic-payments
Thank you so much for bringing up that point. Many FI guys never include those calculations into their budget. You will need a new roof, you will need another car, your appliances will break down. So in my mind, I keep about $300/month for home repairs and $150/month for car repair/used car purchase
I like your conservative approach! We’re fairly conservative as well and like to have an exit strategy in the event things go wrong (though we probably won’t have near the cushion you do). One of the main reasons we are starting to invest in real estate is to create that cushion. We are also tossing around the idea of downsizing in a few years to cut housing costs. And, if/when I get around to really monetizing the blog, that’s an option too.
I am pretty sure I will fall victim to the one more year syndrome due to the unknowns. My saving grace is that I plan to keep my job after FI as a backup plan (we currently don’t have a minimum amount of hours we need to work per month) and maybe work one trip here and there for fun. This will keep my insurance intact which is my #1 FI freak out point. I am also happy that at 38 the major moves in my life are done. Divorced with no kids is an easier life to plan around than married with them. Then again, my cost of living is higher than most who are married with no kids and my road to wealth is longer than those with 2 incomes. So many factors! This whole FI thing is a game and you need to know the rules you are willing to follow and those you are not which essentially means we get to make our own rule books. š
Double check that you don’t have a minimum hour requirement in order to maintain health insurance. That’s quite unusual. Work may not require you to work a certain number of hours, but health insurance plans often cover those who work a minimum of ~30 hours/week. That way, they avoid hiring people to work one hour per week just to get insurance coverage.
Maybe you’re right: I hope so, but do double-check. š
A couple of comments:
“For example, letās say a 30-year-old has $1 million saved. Using the 4% rule, they should be able to take out $40k each year and be reasonably sure their money will last.”
That is not true. The 4% “rule” is based on something like a 30 year long retirement. A 30 year old would need to plan on at least a 60 year long retirement. I doubt anyone has done the analysis for that as the vast majority of people can’t even think about retirement until they reach their 50s but I assume the percentage would be substantially less than 4%.
” I think Iāve been clear about the fact that we are living on the income generated by our assets, not actually spending the assets themselves. So if I wanted/needed, I could take an additional $120k in assets each year (using the 4% rule) to supplement our income. Thatās a pretty good cushion.”
I assume this means you have $3,000,000 in assets. But the 4% rule doesn’t mean you can take 4% of the value of your assets PLUS what ever income those assets generate. It means that you can take 4% of the asset value in total, including the income generated by the assets. In addition, the 4% rule is really applicable only to a portfolio of 50% stocks and 50% bonds. It really wouldn’t apply to rental properties.
Personally, I wouldn’t be comfortable banking on 4% for 30 years, as I noted above. I used the 4% rule because many FIRE proponents use it. We went over some pros and cons of it on Monday’s post which is linked at the top of this page.
I actually have over $3M in assets. If I wanted, I could take the 4% equivalent of $3M out of the liquid portion for many years (a couple decades), then liquidate the rest if I wanted to. I get what you’re talking about with the rental units (can’t count the income AND the 4% for them) but even here I have a margin of safety — they have appreciated greatly, so I could borrow against them if I wanted and have a good amount plus the income that way.
It’s really a moot point for us as we have more than enough just from the income our assets generate.
New blogger here, so take this with a grain of salt….but I believe the research has been done on 60yr retirements, and it was done wonderfully. This is one of my favorite articles:
https://earlyretirementnow.com/2016/12/07/the-ultimate-guide-to-safe-withdrawal-rates-part-1-intro/
Grain of salt needed, because that is *not* what the SWR series concludes (hard to say it concludes at all, as it is up to 59 parts now!). However, it certainly did not conclude you can extend from 30 to 60 years at 4%. When I tried a 45 year run with some reasonable assumptions, it came up with 3%.
Agree with Fred. The 4% rule is widely misunderstood. So, add “risk that I misunderstood” to the the list of risks.
Thank you for the insight and wise counsel. Always learn something important from your posts and from those who reply with their thoughts.
Hi ESI,
I am in full agreement with the margin of safety. We live on a similar household budget so I’m trying to shore up passive income levels to maintain a healthy margin above that. Side jobs and going back to work are always options but you will lose the stickiness of the latest salary so psychologically it may be challenging to go back to slaving in a job for pennies on the dollar compared to what was being earned in the past.
-Mike
I follow a few FIRE blogs that seem to be cutting it pretty close! I’ve been early retired for 10 years already, and most of the blogs I followed back in 2007 disappeared during the financial crisis…
I am super conservative, especially since I retired right before the financial crisis and now after 10 years there is no turning back for me. I have no active income or pension. My family’s budget is about 100k a year for basics plus another 20-30k for travelling. Sounds like a lot, but I live in SF, so my property taxes on a modest home already eat up 15k a year. Childcare costs 18k, Obamacare with no subsidies costs 20k. That’s over half my budget already. Then there’s insurance coverage for everything you can think of (~10k), food (~10k), etc.
I currently have almost 20 years of basic expenses in cash, mainly because I think we are closer to a major top in asset prices. I have rental properties that offset about 80% of our basic expenses, and I also invest in hard money loans. About 60% of my assets are invested in the stock market.
My asset to annual expense ratio is about 120x, it was at 80x (current expenses) when I retired. My expenses were only 50k a year the year I retired, so they’ve more than doubled in retirement… early retirement can have crazy variances depending on each individual’s choices since life can go so many different ways when you are still young.
Healthcare expenses are still a concern for me. Also during the financial crisis, my ratio went from 80x to 40x in a year. Theoretically, early retirees should be mentally prepared for such a scenario, but it’s not easy when it actually happens…
Those are awesome margins of safety and I’m thinking of early retirement in much the same way. It’s sort of “one more year” syndrome but to build that safety net is important for extreme early retirement. I’d much rather work OMY than risk having to go back and find work for a couple years.
Very impressive list ESI. We are still working on the major bucket as well as the safety margins. Hoping to retire around the age you did. We may find ourselves having to work a bit longer to ensure we sleep well at night though. Thanks for sharing your options.
Fantastic job building up a huge diversified portfolio! I’ve noticed that as early retirement proponents become more conservative, the 4% rule seems to drift downward to 3% then 2% and possibly even below. Personally I think it would be pretty sweet to simply live off the dividends and interest of my investments which would be just under a 2% withdrawal rate.
We built in a safety margin for early retirement (at 55y/o) by over-shooting our savings goal and by not including our expected social security income in our estimates. We’ve been living off of our investments and dividends the past 7 years.
We still have a few years until social security income starts; we’ll start withdrawing from our IRAs in a year or two; the past few years our withdrawal rate has been about 2-3/4%. We’re confident that this will work for us.
Our issue is going to be our tax liability as both social security and IRA income will kick in at about 70y/o.
How r u handling medical insurance premiums? I am budgeting $1800 per month for the both of us
Stay tuned. Will cover that issue in early June.
I will have no problem going over 4% a few times in a decade. I think we will have plenty and if my 4% is 200K, I think we will be just fine buying a new car or taking an expensive vacation. I have a 7% growth, so really, if I take out 4-6%, I am still growing at 1%. If there is a down market, I will either cut back or just take dividends as cash to get through the down market. There will be several over the course of a 30 year retiremet. Just know when you are in the middle of one, and spend accordingly. If there are sales on cruises in the middle of a recession, we will take advantage.
Above analysis is incorrect. It was the logic used prior to Bengen coming up with the 4% SWR of thumb (it was always a misnomer to call it a rule), and was the very reason he felt compelled to do the analysis.
Sequence of returns risk can devastate a portfolio if it is prolonged early in retirement and simply subtracting average withdrawals from average returns dramatically undercounts the effects of sequence of returns risk.
We live a pretty frugal life, but do travel. We are living from our pensions.
Assets of approx. 2m, which is increasing by about 3.75%/year just on dividends.
When we started our rule was to take out 1% less than the previous years gains. When we had big gaining years anything we didn’t need we put into savings account and invested into further dividends. We have a dividend machine set up that is working extremely well thru good times and bad. Our problem is we are gaining more than we are spending. Nice problem to have.
Hi,
You mention you have 2 years of spending in cash, but are willing to use them to buy property in case of a real estate crash. When the crash will come how much of these 2 years worth of spending would you invest in real estate?
I am not yet financial independent but working on it. I am aiming for 1 year worth of spending in cash is the bare minimum at all time. Curious to know what you think about this.
Well, I keep adding to the pile, so it’s hard to tell how much I’ll have to spend if there’s a crash.
I wouldn’t go below 6 months of living expenses, but then again I have strong income-producing assets too. If I didn’t have them, I wouldn’t go below a year.
I understand, glad to see we agree on the 1 year rule.
I believe the 4% rule is about as good a simplified rule as anyone can justify. I’ve also run cash flow models on my the retirement numbers in MS Excel several times over the past few years (after carefully deconstructing the model my financial planner’s firm used to generate) and I’ve used some of the free online stuff, and what strikes me is how small tweaks in assumptions for inflation, investment returns, longevity, etc. can change the outcomes quite radically. Of course, the Monte Carlo simulations are best at smoothing out those variables, but its still very dependent on a set of assumptions about the future. Maybe I’m stating the obvious here.
In my own models, what happens is interesting… for the first 10 years things go great, I’m living off investment returns, even growing the nest egg, next 10 years start withdrawing from principal as cumulative inflation effects cause big spending increases. Then in latter years, there is a big sucking sound as massively inflated expenses devour the few remaining dollars – that is unless I tweak inflation/returns a little bit, and presto, I die worth millions.
I guess there is just no way to know. I actually did see this play out somewhat with our parents. All had 30 year retirements thanks to pensions and social security. But with the last to die, those last couple of years were a financial Armageddon as in-home care, and then nursing home and medical expenses exploded into worst case numbers I never could have imagined – and wife and I were pretty well informed with plenty of professional help/advisors.
What really struck me was that it seemed if you had any wealth at all, the system was hellbent on consuming all of it, but if you had nothing to your name, well… you still got taken care of so long as your family was good at working the system. I’m not advocating the latter, other than to say that would be very interested in later life strategies for mitigating that financial Armageddon, because there is a very high chance that most of us will experience it ourselves and/or with own parents at some point.
The other big thing I saw was how prevalent elder financial abuse was. There is literally a billion dollar scamming industry out there for the sole purpose of separating seniors from their money. I know we all think we’re pretty smart and would never fall prey to such things, but in caring for our (now deceased) parents it was eye-opening. And family members can be just as suspect as well. Our parents were fortunate to have us watching over their money, but that still did not prevent the occasional breach – its like fighting a battle on all sides – everything from fake charities to mail order outfits to spendthrift adult children. I have no great solutions other than choose your POA and other responsible parties very carefully.
I agree with MMiguel. Some time ago I saw statistics to the effect that in the last 6 months of life, more is spent on a persons health care than they spent during the entire rest of their life. Having seen a few people in Hospitals, ICUs and Long Term Care Facilities, I have come to believe it is true. For some, who become invalids sooner than later and have no family to step in and care for them, it can become even more expensive.