How Much Money Do I Need To Retire?
Today’s post is a review of the book by Todd Tresidder entitled “How Much Money Do I Need To Retire?”
I bought this book literally looking for someone to tell me how to answer this question and calculate this “magic number”. I was also drawn by the “60 Minute Financial Solutions” subtitle. Quick, painless and minimal effort! If this is what you’re looking for, I will tell you that you can’t judge this book by its cover and you will be sorely disappointed. However, if you want to really understand retirement planning, all of the factors and variables that make this such a complex process and then come out with real solutions to develop a workable plan, then this is a book I highly recommend that you read.
The author presents three models of planning for retirement. All are totally applicable to an early retiree. All build upon one another.
The first model examined is conventional retirement planning. The author’s goal is to expose all of the holes in this model and deconstruct it. Most people trust the numbers spit out by seemingly sophisticated retirement calculators or projections produced by financial advisors. However these projections are based on a series of assumptions including how much money you will spend in every year of retirement, inflation rate during retirement, investment return rate during retirement, sequence of returns on investment during retirement and how much other income you can rely on (Social Security, pensions, inheritences, etc). You also need to be able to predict exactly when you will retire and exactly when you will die (X2 if planning for a married couple). Unfortunately, you have no way to predict and little control over most of these variables.
As these issues were explained, I realized that our retirement plan and views of early retirement in general had more holes than a piece of Swiss cheese. However, in seeing this model deconstructed we were able to find a few pieces of key information that were very helpful in redeveloping our own plan.
First, investment returns and inflation rates are the two most important variables when modeling retirement planning. The author explained that all the retirement calculators and models used by financial advisors are using essentially the same past market returns and inflation rates to make future predictions. Since there is no way of knowing if the future will look exactly like the past, nothing like the past or anything in between the usefulness of these numbers is unknown. Therefore a starting point for how much you need for retirement would be to just use a 4% withdrawal rate as all projections will be in this range based on the difference between past investment returns and inflation rates. Using the inverse of this, you would need 25X your expenses to retire. (For a more detailed explanation of this concept, click here.) If you wanted to be more conservative you could assume a 3% withdrawal rate, meaning you would need 33X your expenses. Being more agressive, you could assume a 5% withdrawal rate, meaning you would need 20X your expenses. In any event, you would need to be flexible and monitor conditions which could be much different than the past.
The second key piece of information that we gained was that even more important than the overall rate of investment returns is the order in which they occur. If you get average or above returns early in retirement, then the traditional models work well because your investments will throw off more growth than you will spend. This allows you to reinvest the extra money and further grow your principal. In most scenarios you will actually grow wealth substantially in retirement despite spending a portion of your assets. Therefore, long retirement times are not an issue. However, if you have below average returns early in retirement you’ll be forced to dip into principle quickly. In these cases, you may run out of money in less than the 30 year time frame typically used for retirement assumptions. To understand this concept, think about paying off a traditional 30 year mortgage. Early in the mortgage, you pay almost entirely interest and so the principal changes minimally. However, making only 1-2 extra payments per year in the early years of the mortgage cuts years off of the mortgage because you decrease the principal of the loan and eliminate all of the subsequent interest it would have generated. The concept with retirement planning is the same, but in reverse. You DO NOT want to eat into your principle early in retirement because it can have devastating effects on your portfolio.
The key then is having an idea what to expect early (the first 10-15 years) in retirement. Unfortunately, there is no way to accurately predict exactly what future investment returns will be or in what order they will occur. However, the author points out that if you look at investment valuations they give an indication that returns may be more or less than historical averages over this key 10-15 year time frame. This is no more than an extension of the addage buy low, sell high. If you buy (or start retirement) when an investment is cheap (low valuation) you would expect it to have higher future returns. If you buy (or start retirement) when an investment is overpriced (high valuation), you would expect it to have lower returns. An interesting statistic was presented by the author using a common method of market valuation, price/earnings (P/E) ratio. In all past scenarios, using a 4% withdrawal rate was 100% successful (defined as money lasting at least 30 years) when retirement was started with a P/E of 18.4 or less. However, when P/E was 18.5 or more, there is a 21% failure rate. All past failures were predicted by market valuation. The current S&P 500 P/E is 18.9. GULP! Factoring in that bonds are near all time low yields, a 4% withdrawal rate forces you to dip into principle on the bond side of a portfolio immediately. UH OH! This would mean to start even a standard retirement today with a 4% withdrawal rate would be to play a game of chicken to see if your money ran out. The need for a better plan for our early retirement became apparent.
The second model is the “Creative Life Planning Solution.” Understanding that financial independence and the ability to retire securely is simply a matter of providing cashflow to cover your expenses indefinitely, the author demonstrates some simple ways to have drastic changes to how much money you need to retire and how quickly you can achieve this. Your ability to retire at any time is simply a matter of getting creative with decreasing your living expenses and finding ways to produce ongoing cashflow. I love this particular quote that summarizes this section perfectly: “…you can repaint the picture of your retirement to look any way you please…”. (See this post for our thoughts on this topic.) Looking at retirement planning in this way, many options became apparent to us. Before reading this book we felt completely trapped by all of the unknowns in the first model, and felt we were a long way from retirement. This book, and this section specifically has drastically changed our outlook on retirement planning and has allowed us to move up our timeframe dramatically. We won’t go into any more detail on this model right now. Essentially, everything we’ve written to this point on the blog and most of our plans and philosophies for early retirement have grown out of reading, thinking about and discussing this model. Essentially, instead of trying to figure out how to fund a traditional retirement, we’re redefining what retirement will be for us.
The final model described in the book is “Cash Flow Planning”. I took three key points away from this section. First, you must focus on investments that will produce income AND grow at or greater than the rate of inflation. Second, to be truly secure in your retirement you can spend income produced by your assets, but the assets themselves can never be touched. Third, your income should come from a variety of unrelated sources.
The author points out that many would argue that these rules create too high of a standard and that this would be too difficult for most people to achieve. His response: “The numbers are the numbers.” We love this response and the author’s focus on gaining an accurate understanding of the issues and focusing on risk assessment, rather than oversimplifying and simply telling people what they want to hear. Our whole journey to financial independence and early retirement is about having a more rewarding and fulfilling life. We have no desire to trade the drudgery of 40 hour work weeks for an equally undesirable lifetime of worrying about running out of money and counting every penny.
In summary, this book is not going to simply give you a number to answer the question “How much money do I need to retire?”. It is also not a 60 minute solution as the title states. This book requires several readings, a lot of thought, playing with numbers and manipulating different scenarios to truly grasp the concepts it contains. For those looking for a deeper understanding of retirement planning this is a great book and I could not give it a higher recommendation. It is especially applicable to the aspiring early retiree, because of the focus on eliminating the risks of longevity of retirement.
When we return after the new year, we’ll continue on this theme by sharing how this book has helped us in developing our own investment portfolio and retirement plan that will allow us to retire earlier than anticipated, with less money in our portfolio than we thought we needed and with greater security than we would have had prior to reading it.