How much is enough ? (part one)

This is THE critical question for FF. Unless you can answer it, you will never know if you are there or not, and you will never have a concrete goal to aim for. Anyone seriously seeking FF should have a specific answer to this question, i.e. a net worth figure and a target date.

Source of image: theintentionallife.com

Initial research

I’ve spent a lot of time on this recently. Obviously before quitting the career and packing up everything to head home after nearly two decades, it’s important to be sure of what you’re doing. The 2008 Global Financial Crisis is still fresh enough in mind to factor in a safety margin.

While I was reasonably confident I had enough, I started doing some research to try and “make sure”. What I managed to find was various numbers on what it costs for a couple to retire, e.g. “The Association of Superannuation Funds of Australia releases a guide to how much retirees need for retirement. They reckon a “modest retirement” is $23,489 for singles and $33,784 for couples. Yet who wants to be modest in retirement? To have a comfortable retirement (holidays, nice wine, trips to the flicks), you’ll need $42,597, and $58,326 (couples). “ – Barefoot investor, 13 Jan 15

Here is another version with four lifestyle categories :

No.	Lifestyle	Single $ p.a.	Couple $ p.a.
1	Doing OK	22,500	32,500
2	Comfortable	32,000	44,500
3	Doing Well	41,000	56,000
4	Premium	54,000	71,500

(Source: Sunsuper, Suntracker brochure)

Of course, most of these guidelines are for the average single or average couple in Australia. You will be hard pressed to find general guidance for a couple in their late 30’s and with young kids, aiming to retire 25+ years before the typical age. And furthermore, it was only answering part of the question (i.e. how much you will spend, rather than the bigger question of how big a nest egg is needed to fund this spending!)

I also found some very extreme guidelines, e.g. “when you can live on the interest on your interest” –mentioned in “ The Rules of Wealth”, Richard Templar. And I thought I was being conservative! That’s an extremely stringent target especially in this recent environment of ultra low interest rates. Even assuming Australian interest rates of say 3% (which are very high versus other developed countries), that works out to 0.03 x 3% = 0.09%. Taking the modest couple requiring $33.8k p.a., they would need $38 million according to this ! And I didn’t even allow for taxes in the calculation!

Still searching for peace of mind before taking the plunge, I decided to take advantage of the free financial advice offered by my industry super fund. This was a worthwhile experience to get myself organized, but the complimentary financial check-up in no way answered my specific questions on early retirement, and I was not keen to shell out extra money for the personal financial advice offered.

Finally some answers

So I continued my search online, and it was a very rewarding and enlightening bonus to discover the world of FIRE (Financially Independent Retire Early). I never knew there was a community of bloggers out there writing about this, the very same thing I had set out to do all those years ago! And in particular it was very valuable to find Mr Money Moustache (MMM), which I have found to be an excellent resource and have been going through it in some detail these past few months. It was only on this website that I managed to find quality information that I felt was applicable to my circumstances, albeit with geographical translation needed from US/Canada to Australia.

So what does MMM have to say on this question :

“The 4% Rule: The Easy Answer to “How Much Do I Need for Retirement?

The answers you get to this question vary widely. Financial beginners (about 95% of the population) tend to randomly just throw out a number between 5-100 million dollars. Financial advisers who aren’t Mustachians will tell you that it depends on your pre-retirement income, (with the implicit assumption that you are spending most of what you earn) and the end answer will be somewhere between 2-10 million.

Financial Independence enthusiasts will have the closest-to-correct answer: take your annual spending, and multiply it by somewhere between 20 and 50. That’s your retirement number. If you use the number 25, you’re implicitly using a 4% Safe Withdrawal Rate, which is my own personal favorite number. “

(Source : MMM The 4% Rule )

It was a relief and gave me a lot of reassurance to find someone who spoke logically and specifically to my questions on early retirement. As I said before, nearly all the general information out there simply doesn’t apply to people still in their 30’s and with young kids.

Example

So how does one apply this? Let’s go through an example of how I would approach it…

1) Take current annual spending e.g. $44,500 (Based on a “Comfortable Couple” as per Sunsuper).

2) Assume a multiplier, let’s chose 40 (A safety margin over MMM’s preferred 25, but still within his suggested 20-50 range).

3) Do the multiplication: $44,500 x 40 = $1,780,000

[ Note: I didn’t consider income tax, but with an income of $44,500 split between a couple of two, the tax rate should be relatively low. Also considering I have been conservative in the multiplier assumption, any taxes should be covered by this safety margin ]

Just to be clear, what exactly does this “retirement number” mean? In my case as a home owner, it is the amount of net worth needed over and above owning my own home outright (mortgage fully paid off). Some might include their own home in net worth and that can be appropriate in some cases. But from a retirement perspective, your home is not an asset providing passive income, and so it does not contribute to this retirement number.

Potential Pitfalls

Please note that home ownership is not mandatory for FF. If you choose to rent, then the above process still works, you just need to ensure rent payments are included in your current annual spending.

The above is an illustrative example only. Obviously you will need to consider different assumptions fitting your individual goals, circumstances and risk tolerance. And accept that it will never be perfect. Of course you could use much more complicated discounted cash flow and statistical models. Please accept these will be imperfect too and I wouldn’t have much more confidence in them based on the track record of most economic forecasters who use such models. In the absence of a crystal ball, a simple and understandable approach suits me fine.

As with any model, it’s only as good as the assumptions and thinking which underpin it, and it can be open to both use and abuse. Try to approach it with an open mind and no pre-conceived outcomes. You will only be deluding yourself if you fudge the numbers. For example, say you are desperate to retire early, so decide on a 30% reduction versus current annual spending (e.g. $20,000 instead of $28,000) and assume the minimum multiplier of 20 to give a retirement number of $400,000. This might serve as a data point for reference, but it’s not prudent to go and quit your job and retire early based on this calculation alone. Before taking such a major life decision, it would be strongly recommend to test the robustness of the assumptions, i.e. 1) try living for at least 6 months on the 30% reduced budget and see if it is really do-able and sustainable, 2) check the average after tax returns achieved on your investments and see if it is in line with the 5% (plus inflation) implied by a multiplier of 20, 3) seek professional financial advice.

Another potential pitfall is the opposite scenario, where the retirement number calculated is so huge that people are de-motivated and possibly give up at the outset. If you experience this, I can only suggest breaking it down into smaller chunks. Every journey begins with a single step. It may seem impossible to reach $1,780,000 when you are starting from scratch. But if you look over 25 years on a straight line basis, that’s $71,000 per annum, which is already much less intimidating, although still a very large number. In reality, most net worth trajectories are far from straight line. Wealth tends to accumulate more rapidly in the later years due to compounding. Try to take a leap of faith and give it a shot. There is not much to lose – even if you don’t quite reach your goals, I’m certain you will still be far in front versus not having bothered about any of this.

Conclusion

The key takeaway message from this post is to spend the time and effort to calculate your specific “retirement number”. Once you have this, FF will no longer be a vague pipedream, but gets transformed into a concrete personal goal with a clearly defined finish line. And now the choice is yours, if you are ready and willing to commit or not ?