Summary: Retirement math is pretty simple. Get the formula right by using the ESI scale to hit financial independence.
As I discussed in My Retirement Budget, Income Allocation, and How I Plan to Diversify, there’s a basic retirement formula.
We’ll get into specifics in a minute, but first let’s revisit what I’ve said.
Here are the main parts of my comment:
Retiring with your assets able to create enough income for you to live on (without spending any of the assets) is a function of:
1. Amount you have saved
2. The return rate you get to produce income
So if you have $4 million and can earn 3%, you’re going to turn out $120k per year.
If you have $3 million and can earn 4%, you get the same amount ($120k per year).
Of course you have to deal with what assets you have access to if you’re below 59 1/2 and have a good amount in retirement funds, which is an issue for me.
So in that case, you can have access to $1 million and if it earns 8%, you earn $80k per year.
In this post I want to elaborate on these comments and do some retirement math. The goal will be to demonstrate that you can retire (and even retire early) at various levels of income and return rates. (FYI, I’ll use “to retire” in this post to mean both retire at a more standard age as well as retire early as I have done.)
To get started, let me adjust what I’ve said above so we can break it down a bit further.
Retiring with your assets being able to create enough income for you to live on (without spending any of the assets) is a function of:
1. The annual income you need to retire. As noted in Your Money or Your Life, your expenses will drop dramatically once you retire (if you want specifics see Living Expenses Drop Dramatically During Retirement and The Best Personal Finance Books of All Time: Your Money or Your Life). So if you need $50k in pre-retirement income to cover expenses you may find that you need $35k or less in retirement.
2. Amount of savings/investments you have access to. For instance, you may have $4 million in assets, but if $3 million of that is in retirement funds you can’t access until 59 1/2, you’re currently 50 years old, and you don’t want to tap your retirement funds (there are ways to do it before 59 1/2), then you have $1 million to retire early.
3. The return rate you get on your funds to produce income. Of course with higher returns come higher risk, so you’ll likely want a blend and have the sources diversified.
Note again that these scenarios (and what’s below) assume you don’t want to spend a penny of the principal you have saved.
Putting the Retirement Math Together
Here’s how the numbers above fit together:
1. How much annual income do you need to retire? The only way to find this out for your specific situation is to create a post-retirement budget. Check out My Retirement Budget, Income Allocation, and How I Plan to Diversify to see how I did it. Also read The Importance of Tracking and Managing Cash Flow for some basics on how to create a solid budget.
2. Know what you have to work with. Hopefully you track your assets close enough that you know what’s available. (I use Quicken, so it’s a snap). If you don’t know, you need to find out asap.
3. Have an estimate of how much each investment could earn in income. For purposes of this exercise, we’ll use one number, but it’s likely a blended rate among several investments. For instance, if you earn 10% with real estate, 7% with P2P lending, and 4% with dividend funds and you have equal amounts invested in all three, your blended rate will be 7%.
Solving for Missing Numbers
For those of you who are math inclined, you can see that if you know what two of the three above are, you can solve for the third (which then tells you where you need to be). Let’s look at those options and start by solving for what return we need.
- Joe needs $40,000 to retire
- Joe has $1.4 million saved
- Simple math ($40,000 / $1.4 million) will tell you Joe needs to earn 2.9% on his $1.4 million to earn $40k a year
- This seems to be a reasonable objective and he can be fairly conservative
Now let’s solve for amount needed:
- Jess needs $50,000 to retire
- She thinks she can earn a blended rate of 5% on her investments
- So she needs $1 million to make it all work ($50,000 / 5%)
- Now she can evaluate how close (or far) she is to retiring
Finally, let’s solve for annual income:
- Jerry has $1.2 million saved
- He believes he can earn 6% on his money
- This means he’ll have $72k in annual income ($1.2 million * 6%)
- After doing his budget, he can determine whether or not $72k per year will be enough for him to live on
A Scenario Using Retirement Math
Now let’s run through a scenario to see how various issues play out.
Let’s say Jimmy needs $50k per year to retire (basically the average annual income in America).
There are several ways he can hit it:
- Option #1: He can have a high amount saved with a low return: $2 million at 2.5% does the trick
- Option #2: He can have a low amount saved with a high return rate: $500k at 10% gets him $50k a year
- Option #3: He can be moderate on both savings and return rate: $1 million at 5% earns $50k per year
Some thoughts on these three possibilities:
- Option #1 seems pretty reasonable. Earning 2.5% isn’t that difficult and he can invest with a good amount of security.
- Option #2 is more challenging. Because he only has access to $500k, he needs to earn a very high rate (probably one that he can’t hit) in order to reach $50k. So his options would be to either save more or supplement his retirement earnings. For instance, he could earn 5% on his $500k to get to $25k and then maybe get a part-time job where he earns the other $25k. Not total retirement, but it gets him partially retired.
- Option #3: This is the one I like best — a healthy savings plus a good but reasonable return rate. It’s fairly balanced and isn’t excessive on either end.
So to summarize: For any annual income number needed, be it $30k a year or $130k per year, total invested as well as return rate can be varied to hit the number in many different combinations.
If you have more saved, you can be more conservative and only need a small return rate.
If you have a small amount of savings you either need a high return rate or you will need to supplement your asset earnings in some other way. Most Americans make up the difference by taking part of the principal and spending it each year but you could also work a part-time job.
Here’s how my numbers sort out:
- After doing my budget, I need $97k a year to maintain the standard of living I want to have.
- I currently have access to $1,323,000 in assets (not tied to retirement accounts).
- So I need my assets to generate an average return of 7.3% to hit my annual goal.
Here’s how they actually perform (based on my budget):
- Rental real estate will return 11.4% on $579k invested or $66k per year
- P2P lending will return 8.3% on $159k invested or $13.2k per year
- My brokerage account invested in index funds will return 1.4% on $585k invested or $8k per year
Those three yield $87.2k of the $97k I need each year. Not enough.
Before we find the rest of the money, let’s discuss the income options:
- My rental places are doing quite well and 11.4% is reasonable considering how they have performed recently. But look at the amount they generate compared to the same amount in my brokerage account. Is it any wonder I say my greatest real estate mistake was not buying more houses? Imagine if the $585k in the brokerage account was invested in more real estate! If I was earning anywhere near 11.4% on that amount it would be a HUGE bonus.
- P2P is doing better than 8.3% now but I expect it to shake out somewhere in this territory over 2017. It could be higher or it could be lower.
- The brokerage account isn’t set up to be income producing, so the $8k there is thrown off by accident. I could sell the funds and invest in dividend stocks/funds to earn 3% or more (moving the amount generated to $17.6k) but I’m sitting on huge capital gains (my cost basis in the $585k is $368k). Anyone with any ideas on how to convert the $585k to income producing assets without paying a ton in capital gains taxes?
Now let’s get back to the situation:
- $97k needed for 2017
- $87.2k produced by the three assets above
In addition to the earnings above I have two other sources of income to close the gap. They are similar to what Jimmy needed to consider in option #2 above:
- I have a minimum of $3,600 in annual blog earnings.
- I have a “plug” number of $8k that I will earn in some fashion before the end of 2017
So that now gets me to $98.8k earned annually ($87.2k + $3.6k + $8k)
Let’s review what could or couldn’t happen in the set-up above:
- 11.4% is a healthy return even for rental real estate so I could do worse. But my recent months have me on a path that’s much better. So this one could go either way.
- P2P is what it is. I don’t think I’ll be much higher or lower for 2017. In the long term (past 2017) I could see it dropping though as more people default on their loans.
- I have an opportunity with the brokerage money if I can avoid the capital gains taxes.
- The blog earnings are completely understated. My former blog earns $3,600 per year now with me doing absolutely nothing. I’m cranking it up again and would say $5k is a more reasonable goal. In addition, this blog should earn at least $1k in 2017 without me doing much other than writing (and I’m planning on much more than that). So $6k is reasonable but I wouldn’t be surprised at $10k or more.
- I’m already getting offers to do work here and there, so picking up an extra $8k seems like a walk in the park. I could work one day a week and make $20k easily. I could also teach (which I’d love to do) and make even more, so there’s lots of upside here.
- I could always cover any shortfall by tapping into my principal. Even if I needed $10k a year the brokerage account alone would last almost 60 years. And once I get to 59 1/2 I have a whole new (and very large) asset base to tap into. In fact, we get access to another $190k sooner than that when my wife hits 59 1/2 and her IRA becomes available.
- We could live on less than $97k per year. I’m a notorious over-budgeter, so it’s likely we’ll actually spend way less than what I have on the books. It could be as much as $20k less, but $10k is probably more realistic.
That’s probably as much retirement math as you want for today — likely a lot more.
Any questions or comments on anything above?
Jon @ Be Net Worthy says
There are many ways to skin a cat as they say. You are in a good position where you worst problem is figuring out how to avoid capital gains on $200k!
I’m assuming all of these figures are after tax? Also, I’m wondering if you are still depreciating your properties? If not, you could consider a 1031 exchange to get into some new ones. I think you could start depreciating again, and with your new lower income, could really take advantage of the tax break.
I struggle with real estate at my income level since I can’t take the depreciation and I feel like the market is pretty frothy right now.
My income numbers are before taxes. Taxes are an expense that are then deducted from gross income, just like any other expense.
I am still depreciating my properties and have lots of time left on them to do so.
SBDad @ Small Budget Blog says
It might sounds weird, but it’s interesting to see the way you’re thinking about these different parts of the equation. You like blogging, so that seems to be one of the most immediate ways to go and you’re already thinking about that.
Back to my comment on your post yesterday, you could use some rental equity to invest. Right now it’s sitting there locked up. You could probably borrow against it at 4-5% and invest it at 7-9% in P2P lending. You would have to consider that it would decrease your rental returns, but if you ran the numbers, I’m guessing it would be a net increase in annual income.
That being said, I’m very debt adverse, so I feel a little dirty even suggesting that. 🙂
Maybe. Since I’ve written this (about three weeks ago — yes, I work a bit ahead), my P2P returns have dropped a decent amount. It’s hard to tell where they will sort out.
I’ll give a clearer update at the start of the new year.
What do you think about drawing down principle, reducing the requirement for a larger rate of return?
That is a good possibility and certainly one worth considering.
As of now that’s my back-up plan…
Jeff B. says
If you have $5M dollars, you can take out $100K for 50 years and have money. At some point, your money is going to grow more than you spend. Even at 4%, taking out $100K a year, you will generate more than $100K a year. We are going to have to force ourselves to fly first class or take a really nice cruise if our investments keep growing and we are only spending $125K a year.
Can you give us a general idea as to your average income throughout your working life? If not, maybe you could share your average annual savings (not from market gains). For example, would you say you saved, on average, $1500/month or $4500/month? What was your average personal savings rate? I feel like I save a good bit (max 401k and Roth), but I have little confidence that I will amass significant non-retirement savings. I would feel great if I could get to $4000/month savings.
Let me respond with several thoughts:
1. I did make a good income from early on in my career. After all, I wrote this post from experience:
This is why I write so much about growing your income/career. It makes things much easier financially.
2. Combine that with the fact that we weren’t big spenders. So the gap between income and expenses got larger and larger over time.
3. This allowed us to invest a lot, mostly into index funds, then later in real estate.
Those three are the E-S-I story in a nutshell.
As for how much I invested, here are some general thoughts that will get us close:
1. Every year since the early 90’s I maxed out my 401k. Not just maxed out to get the full company contribution, but maxed out to put in the most I was allowed to save.
2. I probably saved that much over again in taxable accounts. This is the money that eventually helped me buy my rental properties (plus have a good amount left over). It didn’t grow as fast because it was after tax and it didn’t have the employer match to help it along, but it still became a sizable amount.
If this seems over-whelming to you, check out the first comment on this post for a good perspective on how much you really need to save:
Mike H says
Can you look to take some to all of the capital gains next year, in a year where your other earned income is as low as it can get, thereby putting you into a lower long term capital gains rate? This can be of the non-dividend paying stocks and you can slowly leg into diversifying your portfolio, by keeping a watch list and legging into positions when valuations look to be favorable.
Yes, I have considered this as well.
I’m not sure how doing so will impact my ability to get (if I have any hope of it) financial aid for my daughter (since it increases my income) when she goes to college next year, so that’s a balancing act I’m considering.
I would expect your Expected Family Contribution (EFC) would be nearly equal to your daughter’s college costs. Meaning your family will only qualify for non-subsidized loans from the Dept of Ed and private loans. Both having unattractive interest rates/terms. I would imagine you’ll have better payment options.
The first year of our oldest son’s college EFC was greater than the cost of his college. We never hassled with the FASFA after that. His scholarships were guaranteed for all four years. We were determined to avoid debt for college expenses.
Nice outline of where all your income is coming from.
Expenses will always change both up or down. When my mom and dad retired they did not have a cell phone or internet. Cable was basic. Now that he is 89 cell phone is necessary, internet is now gone and cable is premium because he spends most of his time at home. His pension provided health insurance but when GM went bankrupt they took that away so now he pays for his supplemental. All expenses that he did not have 30 years ago. Who knows what sort of expenses there will be.
Best to be conservative.
If you do any charitable giving you can donate stock holdings and neither you or the receiving charity will have to pay the capital gains tax. Might take a while to burn through 200k of gains but every little bit helps!
Yes! Great idea!
Can you get your taxable income below $74900 (married rate)? Then there are no capital gains tax. Example – If you have gross income of $87200 and say itemized deductions of $25000, and exemptions of $12000 (I assume a 3 person household), then your taxable income is $37900 (74900 – 25000 -12000)….Thus you can move/sell capital gains of $37000 a year and not pay any capital gains tax…It will take a few years, but is a strategy to minimize taxes on those sales and reinvest in dividend paying index funds.
You may have just become my hero! I’m going to check into this!
Can’t do it this year as I have salary from the job I just left, but could do it for 2017.
Just remember to keep below that rate ($74900 for 2015 and $75300 for 2016, and who knows for 2017), otherwise ALL of your capital gains are taxed….This is a strategy I use, but every other year, as I need to bunch up income (capital gains) and deductions so that I can take advantage of it in alternating years.
Mike H says
This was what I was trying to suggest earlier but Glen explained it way more eloquently. Well done!
ESI, The needed amount you calculate (in your case the 97K), is that today’s dollar or inflation adjusted amount for the year and thereafter you need after retirement (say 20 yrs from now, for my case)? Thanks
How does inflation affects the equation? If you need 50K a year now, the same goods – assuming 2% inflation – will cost (50K * 1.02 =) 51K next year and (51K * 1.02 =) 52.02K the year after.
If the answer is that the 50K expenses per year is calculated as Net Present Value then a required earnings rate of x% translates into an actual rate of (x+2)%.
Am I wrong?