Trent of The Simple Dollar wrote this article that appeared on MoneyCentral:
Trent answers a reader's question regarding how long it would take to retire at current income levels if he saved 20% of his income. He used the following assumptions:
- Put 20% of each paycheck into an S&P 500 index fund
- Assume 4% annual raise each year
- Assume that the fund “continued to grow at the long-term historical rate (12%)”
Using these assumptions he concludes that his 20-year-old reader could retire at 41 at current income levels, or at 43 with a 4% “raise” each year, off of the interest and dividends in his index fund.
Under these assumptions, this is reasonable. My calculations saw the interest income exceed current income a little earlier, but I may have implemented the assumptions a little differently. So I agree with the answer under the stipulated assumptions.
I also applaud the appeals to frugality and investing a big part of the paycheck before the money ever hits your bank account. These are excellent tips.
The saving by itself isn't easy to pull off, especially over 20 years, but even assuming he could do that, I probably wouldn't be telling him to sell his alarm clock on his forty-first birthday. This investment strategy probably wouldn't do the trick.
- First, a 12% return for the S&P 500 is on the high side, even historically. I took all 20-year windows of monthly S&P 500 closing prices since January, 1950, using data from here and calculated the average annual return. The average price appreciation for any given 20-year window was under 7.3%. The 20-year sliding appreciation was over 12% for less than 4 years out of the nearly 37 years. The average dividend yield from the S&P 500 from 1960 on is 3.23%, so the average return (appreciation plus dividends) is a little over 10% (assuming dividends in the 50s weren't that much greater than 3%).
- This is the yield before anything is taken out. Fund expense fees are taken out each year, the dividends and capital gains from exchanges within the fund are taxed each year, and the capital appreciation is taxed when the fund is sold. Even with the (now) lower long-term capital gains tax rate, this will take a bite out.
- What about inflation? Unless the withdrawals continue to increase to match inflation, one's standard of living is going to go down. The interest income matches the salary at the beginning, but that fixed amount buys less and less as time goes on.
- The guy will be 41! Didn't he get married? Won't he have kids? Won't he have any kids approaching college age? (Maybe not, but the thought of that isn't very appealing now that I'm married with a beautiful daughter.) Unless his kids take on their own debt, each one going to a private school would send him back to his commute unless he was making $100,000 at age 20. Even if he lives frugally, his biggest expenses will likely be during his forties.
It sure would be nice if that's all we had to do: Work at a job, get modest, standard-of-living, “attaboy” type raises each year, tighten the belt for maybe two-thirds of a typical career to put a large chunk each month into VFINX, buy and hold and not touch it for twenty years, and start skimming the money off for the next forty years, never touching the principal because the market magically grows at 12%, blissfully unaware that the next 40 years are going to bear little resemblance to the previous 40, and paying no heed to the wave of baby boomers that have to sell their stock funds because they're starting to hit that mandatory distribution age of 70 1/2.
Making any assumptions about what you'll need to retire is a sure way to kill your retirement dreams. Being able to retire at age 40 requires extraordinary planning, risk-taking, and hard work, likely even before age 20, likely outside of standard employment channels. The comfort of a steady paycheck by itself — even a decent-sized one — almost certainly won't lead to this kind of early retirement. (Even living by oneself: I'd want to hear the conversation that ensues when the guy tells his wife that he can fund his retirement, but not hers!)
If I were 20 (I'm not) here's what I'd do to have a chance to be able to retire at 40, knowing what I know now:
- I wouldn't get any more letters after my name, except maybe CEO. Advanced degrees in some fields are licenses to hunt for higher-paying jobs, but they take a really long time to get. I was 28 when I finished school. I spent nearly all of my twenties at a severe financial handicap. Not the way to retire quickly. (Actually, of the half-dozen graduates in my church this year, my bets on the most successful of the bunch were on the guy who was going to go to trade school to be a welder! That's going to be a useful skill!)
- I would work to build equity in a business, not to earn a paycheck. Working for someone else won't make you rich enough to retire at 40 — unless, perhaps, your bosses' names are Sergey Brin and Larry Page.
- If I needed a paycheck, I'd work like the dickens after hours to build equity or improve my skill set.
- I'd look beyond the S&P for my investment needs. It's hard to make a lot of money buying what everyone else is buying or what everyone else is telling you to buy. And I almost certainly wouldn't buy and hold! The problem with “buy and hold” is that they never really tell you to “sell!”
- I wouldn't be complacent. Even a rigorous plan like the one above breeds complacency. Why just 20%? Why not as close to 100% as possible?
- I wouldn't retire at 40. I'd be too afraid that I miscalculated somewhere in my predictions about what the year 2034 has in store for me and my investments. I might look for more meaningful work, but not quit entirely.
MBH, I think you got the point of the article exactly. It's meant to be an eye-opener to the people who would get their advice from MoneyCentral, busily managing their 401(k)s and wondering why they're stuck in the rat race. It doesn't have to be that way.
Some thoughts:
1) Agreed that index funds aren't going to cut it. To get that kind of return with any reasonable margin of safety, I would be looking at dividend stocks that consistently raise dividends every year. That way you can lock in your cost basis and your effective yield will increase each year. The index fund won't work the same because of re-balancing, fees, etc.
2) Building equity outside of your 9-5 should probably be emphasized even more. If you want a regular paycheck, that's fine but there is a lot of trial and error involved in building equity outside of your job and the sooner you start, the better off you will be and the more 'diversified' you will be. Income diversification is huge in this scenario.
3) Life has a way of throwing some serious curve balls your way. The reader is assuming noone in is family will get sick, be born with or acquire a disability, steady returns, and a host of other things that make this forecasting extremely difficult. The farther out you go with projections, the higher margin of safety you need.
Enjoy your weekend all!
More realistic estimates using a 4% safe withdrawal rate, adjusting withdrawals for inflation, 100% income replacement level, offering the same standard of living in retirement while saving for it, a more realistic 7% real return, saving 20% per year would require 31 years of work so he had better start when he was 10! Or wait until 50. Even a 10% real return would require 25 years.
Now if he started at age 20 and saved 38% of income with a 7% real return or 30% of income with a 10% real return, or started at 25 and saved 50% of income with a 7% real return or 44% of income with a 10% real return, he could do it.
Very well thought out and researched. Is it possible to retire at 40? Of course, it is. But, more than likely, life will get in the way. Situations change, jobs come and go, stocks go up and down, the one person the paycheck had to cover turns into 2 or 3 or more people.
I think the important part of Trent's article is to diligently save a high percentage of your pay, and to live frugally.
I think your message is also clear: there are too many unknown variable to plan for a retirement beginning in 20 years, and that will last 40+ years.
Your advice about "knowing what I know now" is also very good. 🙂
There is one way he could come close. If he will also pay off a home in that time, then his real saving rate is more like 20%+25% or 45% and this would put him most of the way there. I retired at 43 myself and could have done so earlier if that had been my intent. The alternative of finding something you can do and enjoy is not bad but can be difficult.
I knew this was why it was too difficult for me to retire at 40 (or even in 20 years time). However, it shows more that its pretty close to possible if you live well beyond your means and invest well – you only need a tiny portion of luck rather than winning the lottery type levels.
Did I miss something? The article in question only covered the accumulation phase . . . that is the easy part. A retiree at 40 faces 50 years of living off that portfolio. Fifty years of unexpected expenses, of uncertain inflation levels, of booms and busts . . . what a joke. Try managing a portfolio for both growth and current income and you'll be out of that S&P500 index fund in a heartbeat.
Yes, just because equites average 10% doesn't mean you can live off that. It doesn't return 10% every year and is down many of them. Your capital would also be devoured by inflation over the long term. That is the reason for the 4% safe withdrawal rate rule and the reason the article is way too optimistic as written.
My Jun. 7 post questioned the 12% estimate too.
i like your approach but i m always looking to see a better and constructive approach not only pointing out the bad things. i would love to see the real method of retiring at age 50 if not 40 🙂
Retiring at age 40 should be pretty easy. My wife and I (both age 25) make around $115 combined. We have been saving around $50/year. That is the most we will probably ever be able to save. Our income will go up, but we will have kids and new expenses. But I really think we will always be able to save $50/year. In 15 years we will have around 2.5mil. Even in a joke account we will make around 150/year just on interest. 150/year is more than most couples ever see.
I agree pat, it’s not that difficult if both people work and are committed to a frugal lifestyle by their 20’s. It’s also crucial not to have a boatload of kids (and not to spoil the ones you do have) and to maintain your health to cut down on future medical bills as much as you can.
My wife and I save about 60% of our combined salary; we’re both 32 and on track to retire at 41, barring any catastrophes. It’s shocking how much money the average American wastes on food, furniture, and entertainment.
I understand that saving this much is impossible for many because of high housing costs though. We live in the cheapest apartment we could find, and it isn’t always easy, but we’re willing to sacrifice a little comfort now for thirty extra years of freedom.
I would say retire before 40 isn’t simple but the steps are simple. Cut expenses, maximize income, and save like crazy but on paper that works just trying doing it.
Retiring at 38, 40, 45 or maybe 50 is so unattainable for most if not all people unless you have a much larger than the average 50k per year income. Retiring early and living in a modest apartment is a stranglehold on your finances….rent forever…what do you do for health care????Do you even have any????? Any policy that is reasonably priced has a 10k annual deductible. I don’t care what paltry interest rate you earn (less than 1% for the past couple of years) your interest won’t even cover health care premiums…also, you’ve got to heat your place, maybe take a shower once a week (if you can afford it), oh and maybe watch TV or turn on a light once in a while. Anyone that has retired or SAY they have retired and have worked in a regular 9-5 job is a liar. If I had to lead a lifestyle where I was afraid to walk out of 1 bedroom apt because of high crime, and had to drive a 20 year old car (just the maintenance with gas and insurance will eat up your interest earnings), I would rather work an additional 10 years. If you live like a low life bum just to quit working at 40 — take me off the list…..Again — health insurance, utilities, car and life insurances — don’t fall for these lies. They are just trying to make you jealous.They say they paid their homes off early — fine, but they used money up they were supposed to be saving … it doesn’t make sense…like they are smarter than we are …. NO WAY CAN IT BE DONE…
Good, informative article.
For me, recently self-employed 29 year old, 2 kids, medium size mortgage, retiring at 40 IS a benchmark, not a definite.
Being self-employed allows you to be tax-efficient, and to therefore invest more money into your goal. Being ‘frugal’ has not really been a part of my plan, as living well in the present stops me from dipping into my savings pot.
Personally, I’m putting 50% of my take-home pay (£25k) into my savings and investments, and I hope that should give me a pot of around £450k in 10 years.
This, in theory, would be enough for me to retire on if I can continue to squeeze 10% ROI, through growth and dividends.
However, to me, retiring at 40 is more about relieving the pressure of work. If I achieved my goal, would I retire? Probably not! But it would give myself and the family greater flexibility to do what we want to do, and not to be chained to a desk for a further 25 years!