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?