The internet is full of advice and self-help articles. Unfortunately, most of those articles are too short to provide much in the way of actionable advice or recommendations. I've also found a lot of the material on the internet to be of "questionable" value, and I think that is putting it in the best possible terms. There is also the issue of "just talking up his (or her) book". A lot of websites are simply trying to sell you something; a mutual fund, an ETF, physical gold, investment service/advice, etc. Finally, you have to wonder about the qualifications of some of the internet purveyors as anyone can write an article for publication or put up a website. I'm not selling anything, I don't have a website, and I think my background and qualifications should give readers some confidence that they, or most anyone, can achieve an early and comfortable retirement.
I retired about 2 years ago when I was just a couple months short of 56 years old. Because of our planning for an early retirement, my family and I live comfortably in a nice neighborhood off the income from our investments. That successful outcome was certainly not a given, based on our rather humble start in life.
Up through my early teens, I grew up living between my uncle's farm and my grandparents' farm while my parents worked at various jobs. Both farms were small subsistence farms, and neither had indoor plumbing. My grandparent's farmhouse was all of 1200 square feet with 5 rooms in total.
Baths were taken in a large galvanized tub in the kitchen with water heated on the gas stove. My grandparents grew vegetables, some of which we sold at a roadside stand in front of the house. They also raised chickens for eggs and an occasional steer or hog for meat. I learned all kinds of useful things from my grandparents, including the art of not wasting much of anything including money. I'm probably one of the few SA contributors that also knows how to scald and scrape a hog or how to go fishing with carbide.
While I didn't really appreciate it at the time, we were pretty poor in financial terms. When I got old enough to be a latchkey kid and watch over my two younger brothers, I didn't spend so much time with my grandparents. We did have indoor plumbing at my parents' house, but we still weren't living very much higher on the hog. One of my most vivid memories was of my parents struggling with how to come up with the $9 per week for me and my brothers ($3 each) to have hot lunches at school. So, you should be getting the picture that I wasn't exactly born with a silver spoon.
My wife is the daughter of a part time school teacher mother and a steel mill mechanic father. Born in Pittsburgh, she grew up in a better but still far from a privileged financial environment. Both my wife and I were lucky enough to go to college and earn bachelor's and master's degrees in engineering. I was also lucky enough to have a rich professional career allowing us to live in five different states in the US and in France for a time. Despite our humble beginnings, without a big inheritance, and without a corporate pension, we managed to save and invest our way to a position where we could both retire early. While I don't have an MBA in finance and I'm not a certified financial planner (CFP), I think I'm qualified to provide some advice and guidance on how others can achieve the same outcome.
#1. Understand Your Current Expenses
This is probably the single most important step you can take in pursuit of some level of financial freedom whether it be to retire early, to accumulate enough money to start a business, or to save for a goal like buying a home or paying for college. Today, this is a lot easier to do than it was when I started my career with the advent of personal computers, smart phones, and the slew of financial tracking tools that are available. I'm not going to spend any time discussing which software to use because, for the simple expense tracking I'm going to recommend, it just doesn't matter which software you choose. Pick one you like, and learn how to use it. I'm an engineer, I'm not fixated on smartphone apps, so I use an Excel spreadsheet that I developed. It is simple, I know exactly what formulas and calculations are in the spreadsheet, and I spend only about 45 minutes a month tracking, analyzing, and understanding our expenses. How can you spend so little time and get the information you need?
First, stop using cash unless of course there is a significant discount for cash (more on that later). In lieu of cash, put all your expenses on a credit card. Roughly 90% of our monthly expenses are on a single credit card. The other 10% are charged on another card. The only reason I use two cards instead of one is because I get more cash back for gasoline purchases on the second card. And by all means, use a cash back card. There is no reason to forgo the 2% cash back on your monthly expenses and get up to 5% back for gasoline purchases. The cash back is a bonus because the real purpose of using a credit card (or two) is to capture all of your monthly expenses so that you understand where your money is going.
Once a month, I export my expenses from my credit cards and my online bank statement into Excel, I parse the expenses into categories (groceries, gasoline, clothes, school, restaurants, taxes, insurance, investments, and misc.) and I graph each category of expenses and the total monthly expenses to see how they are trending. As I wrote earlier, it is not important what software tools you choose to use. The goal here is to get your monthly expense data into a form where you can fully understand where your money is going. Once you understand where you spend your money, you can begin to ask yourself if you are happy with your spending priorities.
#2. Estimate Your Expenses in Retirement
I think we spend too much time writing about, reading about, discussing, and debating the question of "How much is enough to retire on?". Is $1M enough or do you need $2M? There is no way to come up with an estimate of how much is enough until you have a decent estimate of what your retirement expenses will be. The starting point for that your retirement expenses is the estimate of your current living expenses you came up with in step #1 above.
To estimate your retirement expenses, subtract out expenses you will no longer have like commuting, work clothing, lunching with peers, mortgage payments, child rearing expenses, etc. and add in additional expenses you expect to have in retirement like medical insurance, leisure travel, tennis, golf, and spoiling the grandchildren. While this seems to be a daunting task, once you sit down with your spouse and work through it, you will be surprised at how robust and accurate your retirement estimate can be in just a couple of hours. If you have difficulty getting a handle on a list of typical retirement expenses, talk to your parents or grandparents to get a full picture. Once you have an estimate of your expenses in retirement, it is pretty easy to estimate how much you need to accumulate in savings and investment funds to provide that level of income.
#3. Calculate How Much You Need to Accumulate
This subject is where a lot of time and print is spent and for good reason. The complication here is not only calculating how much principle you need in order to throw off a given amount of income but knowing (or estimating) how long you will likely live so that you don't outlive your assets. The traditional rule of thumb was to withdraw no more than 4% of your account value annually adjusted for inflation. If a 4% withdrawal in year 1 of retirement worked out to $50,000, and inflation was running at 2%, then in year 2 of retirement you would withdraw $51,000. This rough rule of thumb is supposed to take into account growth of your principle as well as typical life expectancy based on retirement at the age of 65. This approach is much too coarse of an estimate for me, and it clearly cannot account for retiring earlier than 65. For these reasons, I don't recommend using the "4% rule" or any other variation on that theme.
I recommend a more elegant but still relatively simple approach to estimating the income producing assets you need to accumulate to provide sufficient income to cover your retirement expense estimate from step #2 above. To facilitate the discussion in the balance of this section, I'll continue to use $50,000 as the estimated retirement expenses and the desired amount of income your liquid assets need to provide. It should be noted that the current average income of US retirees is roughly $46,000 per year so $50,000 is at least "in the ball park".
I prefer to use a web-based retirement calculator of which there are many. There may be better tools available but the one I use is Calc-XML. It doesn't have a lot of bells and whistles, but it is easy to use and completely understandable. As an example, we can estimate the income producing assets needed to provide an annual retirement income of $50,000 rising with inflation. For this estimate, I will use a conservative rate of return of 5% (3% real + 2% inflation) and a 22% Federal Tax Rate. The input screen looks like this.
The screen above shows the input for income producing assets of $1.5M and $50,000 per year (12 x $4,166.67/mo). I also ran an estimate with $1.0M in assets with the other input being identical. The two summary result screens are provided below. These results show that, for this example, the retiree should have sufficient income starting with assets of $1.5M but, at $1M in income producing assets, could run short of funds after about 26 years. Note that this analysis does not include the benefit of social security payments and does not take into account a monthly pension payment.
There has been a lot of discussion lately on the need as well as how to fix the Social Security Program, and it is clear there will have to be some changes to ensure the program remains solvent for future generations. I believe that prior to 2034, the projected date the Social Security Program will have insufficient revenue to cover expected payments, a fix will be implemented by raising the income limit for FICA taxes, changing the annual social security payment inflator to the chained CPI, and probably raising the percentage of social security income subject to Federal income taxes. The fact that changes will need to be implemented to maintain the program makes it a bit difficult to estimate the retirement contribution for Social Security payments for future generations.
Likewise, pensions are becoming more and more rare every year. Few individuals in the coming decades will have the benefit of a corporate pension. If you are lucky enough to have a pension in your retirement plan, those payments can be taken into account during your planning efforts.
Given that I'm just days away from beginning my 60th year with my spouse not being far behind, I fully expect that the Social Security Program will be making our payments under today's existing tax policy. However, for my personal situation, I chose to ignore the social security payments for retirement planning purposes. When I start drawing social security payments at 62, I'll consider it icing on the cake. If you are wondering why I'm planning to take payments starting at 62, please visit this article. For those wishing to take into account their expected social security payments or pension payments, there are other retirement calculators that allow for that input to be included. One I have used is offered by Money-Zine.
Whichever calculator you use, the end goal is to have an estimate of the investable liquid assets you will need to generate the income you estimated you will need to cover your estimated retirement expenses from step #2 above.
#4. Calculate How Much You Need to Save While Working
Now that you have an estimate of how much you need to accumulate in investable assets to retire at your desired age, you need to figure out how much you need to save and invest in order to achieve your goal. While this is a pretty simple calculation, we are going to rely on web-based calculators to figure out how much we need to invest each month in order to reach our goal. There is still a piece of information missing, however. At what age do we want to quit working and retire? That is a decision that takes some thought and discussions with your spouse or significant other. For this estimate, I'm going to use an age of 55 years for starting retirement, and I'm going to use an asset goal of $1.5M in today's dollars. We'll see how easy (or hard) it would be to achieve that goal by 55 years old. The figure below shows the Calc-XML input screen used to calculate the annual amount you would need to invest at a 6% real return starting at age 20 and ending 35 years later at 55 years old with investable assets of $1.5M.
The result of this input is that you would have to invest $12,986 the first year and increased by 2% each year thereafter for 34 years or roughly $1082/month in a taxable account (not an IRA or other qualified retirement account). While I can't really hear you, I'm expected many of you to be saying something to the effect of "you have to be kidding" or "nobody can save/invest that much every month". The truth is that you can, though it gets a lot harder as the time between the start of your plan and your planned retirement date decreases. If you started at the age of 25 you would need to save/invest $18,000 the first year ($1500/month). If you started at the age of 30, you would need to save/invest $25,650 the first year ($2,138/month). So, clearly the take away here is START EARLY!
The good news is that if you have access to an employer's 401K or if you use a SEP or traditional IRA, it gets a bit easier to achieve that $1.5M savings goal. Using a qualified retirement plan as the vehicle for your retirement savings, you would need to invest only $9,955 the first year increased by 2% each year thereafter for 34 years to reach that goal. Likewise, if you started at age 30 you would need to invest $21,350 the first year in a qualified plan (vs $25,650 in an after tax plan).
If you are planning on retiring at 55 years old and you have passed your 30th birthday, it is going to be difficult to get there. So, what can you change to achieve your goal or at least get closer to it?
- The 6% real return assumption is a healthy return but not a stellar level of return. The average annual historical real return for the S&P 500 index is roughly 7% over the last 100 years. While it is not impossible to beat the return on the index, it is really really difficult to do so with any regularity. The average individual investor's historical real return is closer to 4%.
- You could adjust your planned retirement age out a few years giving you more time to reach your asset goal.
- You could adjust your spending habits during your working/accumulation years in order to be able to save and invest more of your income. I'll cover this in the next section.
#5. How to Spend Less So You Can Save More
I'm probably going to catch some flak for the content of this section because folks often don't like to be told they should be spending less in order to save more. However, I firmly believe many of us in the US consume too much and, as a consequence, save too little. So, without further ado, I'm going to jump right into suggestions on how readers can spend less and save more.
- Don't fall into the trap of "Death by a Thousand Cuts". "Death by a Thousand Cuts" was actually a method of torture used in Imperial China (a long time ago) slowly draining some poor soul of their life sustaining blood. I'm going to corrupt the concept to include all the little expenditures people make during the week or month that slowly drains the money from their bank accounts. You don't have to think very hard to understand what these little "cuts" include. You may have others, but I'll list a few here to get the thinking process started.
- Fancy morning coffee - you will survive w/o a daily double mocha grande coffee.
- Smoking/Vaping - it's bad for your health as well as your bank account.
- Premium Gas - premium gas is a waste unless your car requires the higher grade.
- Oil Changes - follow the manufacturer's schedule not your mechanic's.
- ATM Charges - Use your own bank's ATM; transactions are usually free.
- Lawn Services - cut your own grass, it's cheaper and you need the exercise.
- Use a cash back credit card for EVERYTHING. If anyone really wanted to know how I spend my money, all they would have to do is get hold of my credit card statement. As I noted above, fully 90% of what I buy is on one credit card and the other 10% is on another. I get at least 2% cash back on every purchase. The only expenses I don't put on a card are my property and income tax payments. And yes, you have to have the discipline to pay the card balance off every month without fail otherwise, the interest charged on the unpaid balance will more than offset any cash back savings you might get.
- Credit cards can be a great way to earn interest on the monthly float and can provide you cash back on every purchase. But you should never carry a balance and end up paying interest on your purchases. This is probably one of the most difficult recommendations for people to implement because it means that if you cannot afford to pay for the purchase in full by the end of the grace period on your credit card account, DON'T MAKE THE PURCHASE! I've had a credit card since I was about 19 years old, and I have never paid a finance charge.
- Don't borrow money on a depreciating asset. The biggest hurdle for implementing this recommendation is buying a car. It is difficult, especially when just starting out, to buy a car any other way. In the last 42 years, I've had exactly two car loans. The first was when I bought a new Ford Mustang fresh out of college. It was a 48-month loan that I paid off in a little over 16 months. The second was in 2013 when we bought a new KIA Sorento, and KIA was offering a loan with no interest for the first 12 months. I never turn down free money, so I took the loan and paid it off at the end of 12 months. Borrowing money on a car is becoming a serious problem today. Loan terms have stretched to 72 and even 84 months for some pricey models. The first two years of ownership include a large depreciation hit as high as 30%. Those long loan terms ensure that you are upside down on your vehicle purchase from day one until roughly the last 18 months of payments.
- Don't lease your personal vehicles. The only thing worse than taking a loan out to buy a car is leasing it. If the only way you can afford to drive a particular vehicle is through a lease, set your sights lower, buy what you can afford to pay for, and drive till the wheels fall off.
- Eat out less. Face it, restaurants are expensive and, when we do indulge, we typically eat well more than we should be making us fatter and less healthy. My 17-year old son recently learned this lesson. My son loves a good hamburger and so he was frequenting FiveGuys, CharGrill, and McDonald's after school and on weekends and his bank account was showing the strain. I suggested that he stop at the grocery store and pick up a package of pre-made frozen burgers and a package of buns next time he craved a burger. He did and when he got home he said "Dad, how come it is so much cheaper to buy hamburgers at the grocery store".
- Use cash when it is advantageous to do so. I'll explain this recommendation using a simple example. About 4 years ago, a very large shade tree in our front yard died. I do a lot of my own yard work including, at times, tree removal. This particular tree was only about 30 feet from the front of the house and roughly 30 inches in diameter and 60 feet tall. I chose to use a professional tree removal company for this one. The initial quote for taking down the tree and removing the debris was $1,500. I asked the owner if there was any discount if I paid in cash, and after confirming that I meant payment with cold hard Franklins, the owner said he could do it for $1,200. I don't generally make payments in cash, but this is an example of when it was advantageous to do so.
- Make purchases online. The advent of the internet has been great for online shopping and price comparisons. I buy a lot of stuff online mostly through Amazon and eBay though I do get our terrier's dog food and biscuits delivered to our door through Chewy.com. It is seldom that I can't find an online price better than local brick and mortar store pricing. I have an example to drive home the point. One of the SUVs we owned was a Hyundai Santa Fe that developed a rattle whenever the AC was turned on. After a few minutes in the garage with a stethoscope, I figured out it was the idler pulley ahead of the AC compressor. So, I called the Hyundai dealer to find out how much it would cost for the dealer to replace it. The estimate I got back was $484. Given it was nothing but an idler pulley, I balked at the price and asked how much the part alone would cost. The dealer wanted $162 for the pulley alone. It's just a nylon pulley with a $2.00 bearing pressed into it; it can't cost $162. At that point, I decided I'd search for the pulley online. I found the part number online and googled up the pulley. It was a generic nylon pulley that ended up costing me $16.72 delivered to my door. It took me about an hour under the vehicle to replace that pulley. While shopping online doesn't support your local brick and mortar businesses, it is a lot better for your bank account. You'll have to decide where your priorities lie.
- Prepare your own income tax returns. I find it amazing that only 33% of US filers prepare their own income tax returns. By preparing your own tax returns, you save on the cost of a CPA or other tax professional to do it for you plus you will understand much better how to reduce the income taxes you pay by maximizing deductions or deferring income. It's not that hard and you have the potential to lower your tax bill.
The list above is not exhaustive, and I'm sure readers will come up with additional examples and ways to lower your expenses and increase your savings. I'll sum up this section by saying "live within your means, lower your expenses, and increase your savings/investments". With a good handle on your monthly expenses and what you need to be saving every month to retire when you want, you will be well equipped to make decisions with respect to prioritizing savings versus expenses.
Where to Invest All Your Extra Savings
As I alluded to in section #4 above, it is pretty difficult to beat the S&P 500 returns consistently and while the S&P has returned about 7% (over and above inflation) historically, individual investors only average roughly 4% returns long term. While we do have a portfolio populated with individual stocks, it represents a relatively small portion of our total portfolio. The bulk of our investments and in particular our qualified retirement accounts are invested in Vanguard mutual funds. My rationale for putting our retirement monies into mutual funds is to ensure we have broad diversification for those funds that we are truly counting on to provide for our retirement years. Vanguard is generally considered a conservative and maybe even stodgy mutual fund company. But, for our retirement accounts, I consider stodgy to be a good trait.
Vanguard has a S&P 500 Index Fund (VFINX) whose performance tracks the index very closely as expected. Over the long haul, you would have a difficult time finding an investment that would provide better returns. Vanguard does have a couple of funds that do routinely beat the S&P 500 index and I have both in our retirement investment portfolio. Two of my favorites are the Vanguard Health Care Fund (VGHCX) and the Vanguard Wellington Fund (VWELX). The Health Care Fund is a sector specific fund so may not be as diversified as, for example, the S&P 500 Index Fund or other large cap equity funds so I do maintain a more limited exposure to the Health Care Fund. The Wellington Fund is a balanced fund with roughly 60% of assets in equities and 40% in fixed income assets. If you look at the historical performance of the Wellington Fund, you will see that it has provided consistently good returns over a very long period of time. I also invest in the Vanguard Dividend Growth Fund (VDIGX), the Vanguard Mid Cap Growth Fund (VMGRX), the Vanguard Capital Opportunity Fund (VHCOX), the Vanguard Energy Fund (VGENX), and the Vanguard Energy ETF (VDE). The latter two funds are rather recent additions as I fully believe we are past the "lower for longer" crude oil price period, and those companies whose business is production and delivery of primary energy sources will do well over the next couple of years.
Readers will note that VDIGX and VHCOX are both currently closed to new investors. Vanguard periodically closes funds when the fund manager can no longer find equities at fair valuations. While this annoys some investors, I appreciate this policy as it helps prevent investors putting money into a market or sector that the professional fund manager believes is currently overvalued. Vanguard generally reopens closed funds when market valuations drop to levels where the fund manager can deploy additional funds and expect a reasonable return going forward. Readers will also note that the only index fund in my list above is VDE. I strongly favor managed funds over index funds with VDE being an exception.
There are many other good mutual funds and mutual fund companies, but you will be hard-pressed to find the consistent performance in both up and down markets, combined with the lowest management fees in the industry that Vanguard provides to investors.
An early retirement is within reach of many people, particularly those that set their goals, do the necessary retirement planning, and diligently stick to their retirement investment plan starting in their 20s. An early retirement may require some adjustment in spending habits during the asset accumulation years but few rewards come without some level of sacrifice or adjustment. You just have to decide that leasing a new car every 2-3 years and a daily double mocha grande coffee isn't as important as being able to retire at 55 instead of 65.
Disclosure: I am/we are long VDIGX, VGHCX, VWELX, VMGRX, VHCOX, VGENX, VDE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.