Saving and investing large amounts of money every year is a great way to get wealthy. Every year your new investments add to your portfolio value, and the investments grow on their own over time. Eventually you have a lot of money.
Growing your investment portfolio is only half of the secret to reaching financial independence. The other half is keeping your expenses low.
Why Expenses Are Important
The lower your expenses, the less income you need each year to fund your lifestyle. In our case, our income during retirement will come primarily from investments like bonds and equities.
If one spends $30,000 per year, then they will need a portfolio value of $750,000 to $1,000,000 if they plan on spending 3% to 4% of their portfolio value each year. The 3% to 4% is called a “Safe Withdrawal Rate” or SWR in the financial planning community.
Safe Withdrawal Rate
The Safe Withdrawal Rate is a general rule of thumb financial planners use to estimate how much an investor can withdraw from an investment portfolio each year without running out of money during the investor’s lifetime. The rate is lower if you want to fund a longer retirement, since you must leave more money invested over time to ensure your portfolio doesn’t run out of money.
For a very early retiree in their 30’s or 40’s, a withdrawal rate around 3% to 3.5% is probably safe and will ensure the very early retiree has plenty of funds available during their lifetime. Someone retiring at a traditional age in their late 50’s or 60’s might select a 4% withdrawal rate (or higher if they expect significant pension or Social Security payments).
The impact of a slightly different withdrawal rate can be huge. Since I retired in my 30’s, I plan to use a withdrawal rate around 3%. In practice, this means I can withdraw $30,000 from a one million dollar portfolio. If I had a retirement budget of $75,000, I would need a $2,500,000 investment portfolio ($2,500,000 x 3% = $75,000).
Now let’s pretend I was 60 years old and planning on a more traditional retirement with social security starting in my late 60’s. I could take a little more risk in the amount of my portfolio withdrawals, and I would be able to choose a higher withdrawal rate, like 4%. To the casual observer, the difference between 3% and 4% seems tiny. Only 1%, right?
In fact, the 1% difference means the 30-something early retiree must have a much larger investment portfolio than the 60 year old. Let’s look at the numbers.
At a 4% withdrawal rate, a retiree only needs $750,000 in investments to withdraw $30,000 per year. A $1,875,000 investment portfolio will produce $75,000 in annual withdrawals at a 4% withdrawal rate.
To summarize, the 30-something early retiree needs $1,000,000 to be able to withdraw $30,000 per year, whereas the 60 year old retiree only needs $750,000, or $250,000 less than the 30-something guy.
For higher withdrawals at $75,000 per year, the 30-something guy needs $2,500,000 whereas the 60 year old only needs $1,875,000. The 60 year old, using a 4% withdrawal rate instead of a 3% withdrawal rate needs $625,000 less than the 30-something guy! A seemingly small 1% change in the withdrawal rate led to a huge $625,000 difference in how much is required to fund retirement.
I have to point out how withdrawing more money each year to fund annual expenses means a larger investment portfolio is required. Take the 30-something early retiree. At a miserly spending level of $30,000 per year, the 30-something needs “only” $1,000,000. Choose the high life by spending a generous $75,000 per year, and the required investment portfolio value balloons to $2,500,000!
The 30-something early retiree would need an extra $1.5 million to fund the higher spending level! For most people who aren’t rockstars or NBA point guards, saving a million dollars is hard enough. Saving another $1.5 million could take many more years or decades, meaning retiring to a life of luxury is unlikely in one’s 30’s.
Many people won’t be comfortable living on a mere $30,000 or so per year, and as a result might find that work isn’t so bad and stick with it for many years to fund a more lavish retirement (and spend more along the path to retirement!). That’s okay too, and a choice each person should make. The point I am trying to illustrate is that the less you spend, the less you need to save in your investment portfolio to fund your early retirement.
Less Spending Leads To More Savings
At this point, I assume I have done my job of explaining how lower spending means you need less money to retire early. Spending less money each year also means you can save more money! It makes perfect sense when you think about it. If you don’t spend all of your paycheck, you have to do something with what is left over. Put it in your checking account. Stuff a bunch of benjamins under your mattress. Or you could be a responsible and boring savvy saver and put it in your IRA or 401k. Quite often, boring people have large, exciting investment portfolios.
In my next post, I review the story of a set of fraternal twins, separated at birth, but both prone to saving. One twin is a Super Saver and manages to retire at a very early age. Stay tuned!
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