“I know I need to save more… it’s just that I never have any money left over at the end of the month!” I hear this often. Most people don’t earn enough to save money. Some people are barely scraping by. Life is expensive.
The truth is though, we adjust our spending subconsciously all the time. What if you received a 5% pay cut tomorrow? Or, if you’re self employed, what if you happen to have a slower month? Does the world stop spinning? No, you simply adjust. Maybe you eat out less each month. You cut back on your shopping. You skip the daily latte. Your flexibility helps you make it through.
Let’s move in the other direction, however. What if you received an unexpected raise? Do you continuously account for merit increases? Inflation adjustments? Do you update your budget to show you can now afford to upgrade to a large popcorn at the movie theater every month? Of course not. For small fluctuations in income, we tend to just naturally adjust, almost subconsciously. Over time, these small course corrections add up, and before you know it, lifestyle inflation has robbed you of your ability to save money!
Lifestyle inflation doesn’t necessarily mean buying a boat or a mansion. It is usually quite incremental and sneaks up on you over time. Maybe you just start eating at restaurants a few extra times each week. Or you start buying slightly higher priced clothing. Maybe when the Civic stops running, you let the car salesman talk you into the more spacious Accord. Or you move to a slightly nicer house, in a slightly more expensive neighborhood.
While your lifestyle (and subsequently your expenses) increase over time, your happiness does not. Seriously. This is known as hedonic adaptation, and it’s robbing you of your money! It’s subtle though- you may not notice the hedonic treadmill while you’re walking on it, but you will when you’re still working in your 70s.
You’re a Hazard To Your Money
My mom taught me a trick when I was in high school that always stuck in my mind. As she would pay bills and balance her checkbook, she would always keep $100 hidden from the balance. It was in the account, but her hand ledger never showed it. “I pretend it isn’t there. I never see it, but it protects me from overdrafts if something goes wrong” she said. She was hiding money from herself. I was intrigued.
What if we take this idea to the next logical step? What if we acknowledge that lifestyle inflation can happen to the best of us, and protect our money from our own human nature? Here’s an idea: set your 401(k) contribution at work as high as you possibly can. My employer lets me contribute 50% of my paycheck. I never see the money come into my checking account, so it’s hidden from myself. No way to inflate my lifestyle with money I don’t see!
Set It And Forget It
No 401(k) available to you? The same trick works with direct deposit. You can ask your employer to direct deposit 50% of your money into a separate savings account, preferably at a separate bank from your checking, so you never see the money. And when you can’t see the money, you can’t spend it. Instead, those dollars stay in your accounts, working for you.
Even better idea- did you know you can configure Vanguard to accept direct deposit? It’s easy, and it works for both taxable and tax sheltered accounts! Throw your money into VTSAX, or choose an all-in-one fund like the LifeStrategy fund I described in last week's investing post. Set it to 50%, forget it, live your life, then automatically join the FI party in a decade!
Start Now
Tricks like these work best if you apply them on your first day of work, at your first job, right out of school. Why? Because you’ve never had a regular paycheck before, so you aren’t ‘used to’ having more money around. There’s no headroom to ever allow lifestyle inflation to creep in. In my 20’s, one of my college professors told my wife and I to “live like college students as long as you can!” I didn’t understand what he was talking about at the time, but looking back, I’m fairly certain it was this. If I had taken his advice, I’d have been FI years ago.
Of course, if you are later in your career, there’s still time to change things. You can drastically cut your spending each month and increase your savings rate, and getting rid of the money from your checking account is a great way to put the pressure on. Go big- try 50% or more. Think that’s impossible? Re-read how we increased our savings rate to over 80%. Remember: you can always transfer some money back to your checking from your hidden accounts if you go too aggressive, so start now! Just keep that extra hundred handy in your checking as you adjust to your slim new cash flow so you don’t overdraft.
Want to take this idea even further? Get into the good habit of giving your hidden accounts additional bumps each year. Whenever you receive a merit increase, inflation adjustment, or bonus, never let your checking account see! Instead, add that percentage to one of your hidden accounts right away. Your cash flow never changes, and the money is never missed.
Summary
Sometimes, it makes sense to take extra steps to protect ourselves from our own destructive tendencies, or trick ourselves into meeting our goals. Trying to lose weight? Never let donuts or other unhealthy sweets into your house. Want to become more social? Get a job that forces you to interact with people on a daily basis. Spending too much time in front of the TV? Hide it in the attic, or sell it on Craigslist. Want to stop snoozing? Put the alarm clock out of arm's reach on the other side of the room.
Want to save money? Hide it from yourself! Don’t look at it. Leave it alone and let it grow. In a decade, you’ll be very glad you did.
Investing is a topic that confounds many of us. The financial industry has taught us that investing is inherently complex, and we therefore need professionals to handle it for us. But it doesn't have to be this way!
For those pursuing financial independence, almost everything you need to know about low-cost index investing can be found in JL Collins fantastic stock series, or better yet, his newly published book The Simple Path to Wealth.
There's not much I can add to the discussion- these resources really are the best on the subject. Instead, my goal for this post is to create a concise investing reference that I can point my friends and family to when they ask me for investing advice.
It's too important of a subject to skip: investing puts your dollars to work, earning more dollars for you completely passively. This makes investing a core tenet of Financial Independence, and what actually makes the 4% rule possible. In his book, JL Collins describes three steps on the simple path to wealth:
1. Spend less than you earn
2. Invest the surplus
3. Avoid debt
Do only this, he says, and you’ll wind up rich. It seems simple, yet so few people understand just how to invest effectively. Banks and shady financial advisors argue investing is a task best left to professionals, as they happily take your life savings and put it into numerous high cost actively managed funds that make them plenty of money, but not you!
Perhaps you’ve tried to manage your own 401(k), but aren’t sure what investments to choose, or in what ratios? Let’s keep things simple as we demystify investing and review the most common mistakes. But first- are you sure you're ready to invest?
Prerequisites
Before you start investing, you need to get rid of your debt. This includes revolving credit card debt, student loans, car payments, etc. Mortgage debt is OK if the interest rates are low, but every other form of debt needs to be paid off. Remember: Your debt is an emergency!!
The only exception is employer matching: if your employer offers 401(k) (or similar) matching, it's probably a good idea to contribute up to the match, even while repaying debt. With matching, you get free money while simultaneously lowering your tax bill at the end of the year.
Once all of your debt is paid off, you should save some additional cash in a savings account. Commonly referred to as an emergency fund, this money is important because it is completely liquid and readily available. How much cash is enough? Popular recommendations call for three to six months of essential expenses to cover the bills in an emergency. This isn’t a bad idea, but remember the more dollars sitting in your bank account, the less dollars you have working for you.
I keep about $10k handy in the bank that I don’t touch. I try to keep everything else invested, so my cash drag is low. Everyone's numbers will be different. The more you have in investments, the lower your cash position can become, since an emergency would constitute a smaller the percentage of your total portfolio.
Terminology
Let's start with a high level overview of some basic terminology. Skip ahead if you already know this stuff:
Bucket vs. Investment
A bucket is a container for your investment dollars, such as a 401(k), IRA, or Brokerage account. These are just account types, like a checking vs. a savings account. They just hold the money.
One or more investments are held within a bucket. Investments include individual stocks & bonds, as well as mutual funds and Exchange Traded Funds (ETFs).
Taxable vs. Tax sheltered
The best buckets are tax sheltered. The specifics vary from country to country, but in the USA, examples include 401(k)s, Traditional and Roth IRAs, HSAs, TSPs, 403(b)s, and 457 plans. While the details of each account type vary, they all allow some form of tax benefit, such as tax-free growth or tax deferral.
While tax sheltered accounts are preferred, most have contribution limits that prevent investors from contributing all of their investment dollars in these buckets alone. This is where taxable buckets such as brokerages come in. In a Taxable account, there are no contribution or withdrawal limitations, but you are taxed annually on both dividends and capital gains.
Stock vs. bond
Stock is a share of equity ownership in a company. It is a claim on a company's assets. When you purchase stock, you become an owner of that company, usually with the right to vote and a right to future profits.
Bonds are a form of debt ownership in a company or government. When you purchase bonds, you become a creditor to that company or government. That entity owes you money and repays you according to the terms of the bond.
This makes sense if you look at the fundamental accounting equation:
Assets = Debt + Equity
From the point of view of a corporation, bonds (as well as notes and bills) are debt, while stock is equity. It is important to note that when assets are constrained, bondholders get paid before shareholders. This is why stocks are riskier than bonds, while also providing a higher return on investment.
Mutual fund vs. ETF
A mutual fund is a collection of stocks and bonds, usually combined according to a common theme. For example, a large cap fund holds stock of larger companies, while an income fund usually holds a large percentage of bonds.
ETFs are Exchange Traded Funds, and are collections very similar to mutual funds. The difference is primarily the way in which they are traded; notably, mutual fund values change once daily, while ETF values change continuously throughout the day like an individual stock.
Active vs. Passive Funds
Active funds are a collection of stocks, bonds, and other investments that are carefully chosen and managed by a team of people. These investment managers usually try to ‘beat the market' averages to give higher returns to investors.
Passive funds, also known as index funds, are not actively managed by a team of people. They simply follow a known index, such as the S&P500. This keeps their expenses far lower than actively managed funds.
Portfolio
Your portfolio is simply what you call your entire collection of investments across all of your buckets. Portfolio allocation describes the total balance of investment classes across your buckets.
For example, if I have a $100,000 invested in a 401(k) with 50% stocks and 50% bonds, and I also have $100,000 invested in an IRA with 100% stocks, then my entire portfolio consists of $150,000 of stocks and $50,000 in bonds, with a total value of $200,000 and a stock / bond ratio of 75%/25%.
The Pareto Principle
Now that we have the basics down, we can discuss how to invest. But the topic of investing is enormous… where do we begin? And because everyone's situation is unique, how can I give advice that's applicable to a wide audience of potential investors?
Let's use the Pareto Principle. Also known as the 80/20 rule, it states that in many domains, 80% of the effects come from 20% of the causes. Some examples: 20% of a company's customers generate 80% of their profits; 20% of the bugs in software create 80% of the crashes; etc. While more of a rule of thumb than a strict law, it comes in handy in describing cause and effect a number of fields.
How does this apply to investing? You really don't need to become an expert investor! All you need to do is have a basic understanding of how investing works and avoid the most common pitfalls (the 20%), and you'll do better than the vast majority (the 80%) of the investors out there! It turns out, there's really only three major principles you need to follow to become an above average investor. Let's discuss each of these in more detail.
Tax Sheltered First
This is where I will have to get U.S. specific, but the idea applies in other countries as well: ALWAYS max out your tax advantaged accounts before you put a single penny of your money into regular, taxable investment accounts. In the U.S., tax sheltered accounts are your 401(k), IRAs, HSAs, 403(b)s, etc. SO many people get this step wrong. Let’s discuss this, Q/A style:
Q: When you say ‘max out’, you mean just contribute as much as my employer will match, right?
A: Wrong. I mean Max. It. Out. In the U.S., at the time of this writing (2017), you can contribute $18k to a 401(k), $5.5k to an IRA, and, if you qualify, $3.4k to an HSA each year. That’s $26.9k per person that can be tax sheltered. Even more if you own your own business. It's OK if don't have enough income to max them all out. But until you can, you shouldn’t put your money anywhere else.
Q: My company doesn’t offer any match. Should I still max out my 401(k) or similar tax sheltered account?
A: Yes. The tax advantages over time are that valuable!
Q: My company only offers a handful of investments and they all have high expense ratios. I should invest elsewhere, right?
A: Wrong. Max it out anyway. The tax advantages almost always outweigh the expenses. See Addendum I on this JL Collins post for more details.
Q: Won't I have to pay a penalty if I put all of my money into a 401(k) or similar and start withdrawals before traditional retirement age?
A: Not necessarily. There are plenty of ways to get your money out while avoiding the one time 10% tax penalty. Additionally, even with the penalty, the tax advantages of these buckets still blow taxable investing out of the water. To the tune of hundreds of thousands of dollars over time.
Q: Do I even have any tax advantaged accounts available to me?
A: Yes. Most employers offer 401(k)s or similar accounts. If you don’t qualify, you can always contribute to an IRA. As of 2017, if you earn more than this limit, you may not be able to deduct your IRA contributions. In that case, you might contribute to a Roth IRA. If you earn more than this limit, you can’t contribute to Roth either, but, you can always go back to the traditional IRA with no deduction. Want to contribute even more to tax sheltered accounts? Other options to google are Backdoor Roth and Mega Backdoor Roth contributions (no guarantee these two options will last forever, though).
Only after exhausting the above buckets should you consider contributing to taxable brokerage accounts, and even then, place your investments carefully. Keep bonds and REITs in tax sheltered accounts only, because they are not tax efficient. See this post for more details.
Q: Is there a priority to these tax sheltered buckets?
A: For simplicity, I like the idea of maxing out the 401(k) or similar account first. As of 2017, you can contribute up to $18k per year to it, and it lowers your taxable income saving you even more at tax time. Next, if you have access to a Health Savings Account, I recommend maxing that out. Mad Fientist considers this The Ultimate Retirement Account because of its unique features. I like it because it lowers my FICA tax expense every paycheck and leaves me with a sweet tax-free account for health costs in FI. Once you max these out, move on to the Traditional or Roth IRA buckets as appropriate given the limits described above.
Q: So with tax sheltered buckets, I never pay any taxes?
A: Not quite. You still pay taxes, just different kinds, and at different times, depending on the bucket. Without going into too much detail, the gist is that almost all tax sheltered buckets grow tax-free, so you'll have no dividend or capital gains taxes due when you rebalance your 401(k), for example.
401(k)s and IRAs defer taxes until you withdraw, when it is then taxed as regular income. Roth 401(k)s and Roth IRAs, on the other hand, are funded with already taxed money, so they are not taxed again on withdrawal. Health Savings Accounts are like the best of a traditional and Roth IRA combined: no taxes going in, tax free growth, and no taxes on withdrawal for qualified health expenses.
To contrast these, regular taxable brokerage accounts offer no tax savings. They are funded with already taxed money, and realized capital gains and dividends are taxed every year. The good news is many early retirees have annual expenses low enough to be in the sweet spot for the 0% capital gains tax rate!
Q: Couldn’t I get to FI quicker by leveraging my money in the real estate market instead of stock market investing?
A: Possibly, yes. But leveraging is not without risk. Additionally, the real estate market is not as simple and passive as the stock market. It requires more of your time and energy, which is a trade-off. If you enjoy it, and are handy, than yes, real estate can jump-start your path to financial independence. But when you are going through an eviction with a tenant who owes three months of rent, as I happen to be, it changes your perspective a bit. Personally, I would only pursue real estate and other investment opportunities after maxing out your tax sheltered accounts.
The main point here is that the tax benefits of these accounts over time is extremely powerful, and often underestimated. Check out this graph from the Mad Fientist:
This doesn’t even take into consideration the benefit to you at tax time while you are employed. Most of your contributions to tax advantaged buckets come right off the top of your taxable income, lowering your tax bill and giving you even more money available to invest! The very first year my wife and I maxed out our 401(k), we saved over $3k in taxes. Everyone talks about the benefits of mortgage interest at tax time- but maxing out your 401(k) is so much better because you get to keep the money! It is your choice: pay Uncle Sam, or pay yourself. Which will you choose?
Now, I do have a few friends who are tax professionals that can probably whip up some specific scenarios where it might make sense to put more money into taxable accounts instead of tax sheltered, say, to claim losses to offset other possible gains in specific tax years. But these are not common scenarios, and probably only involve higher earners. As a rule of thumb, you won't go wrong maxing out tax sheltered accounts first and foremost.
One or Two Index Funds Per Bucket
This is another place I see people go wrong. When setting up their 401(k)s, many people do this:
Investment
Percentage
Actively managed small cap fund
27%
Actively managed large cap fund
15%
Actively managed international fund
10%
Actively managed growth fund
30%
Actively managed income fund
10%
Actively managed core value fund
8%
Instead of this:
Investment
Percentage
Total stock market index fund
90%
Total bond market index fund
10%
For stocks I recommend VTSAX; for bonds, VBTLX. Let’s discuss:
Q: I thought having a diversified portfolio was important. Why only two funds??
A: You are talking about unsystematic risk, which is true for individual stock holdings (say, TSLA, for example), but not for broad based index funds. The funds shown above are total market funds: these hold a piece of every company in the united states. The total bond market fund does the same for bonds. Because these funds are already diversified, all that is left to choose is your stock / bond ratio.
Q: How do I choose a stock / bond ratio?
A: I have 90/10 in the example above. Later in life, I might pick a more conservative 80/20 or 70/30. I recommend never going below 50% stocks, because the 4% rule starts to fall apart with too high an allocation of lower earning bonds.
Q: Where’s the International, REITs, Commodities, Gold, BitCoins, etc.
A: Here's that Pareto principle in action again. The two funds I recommend give you the 80% of the return (or significantly more according to JL Collins) with 20% of the effort. S&P 500 already has international exposure and REITs baked right in. You can add standalone International and REIT funds if you want, but there is a point of diminishing returns.
Q: Could I get even simpler and just have one global fund that does stocks and bonds?
A: Yes. If you are willing to accept some slightly higher expense ratios, Vanguard offers many unique funds that do just this. Check out their Target Retirement funds, LifeStrategy funds, Balanced fund and Managed Payout fund (just remember not to select a fund whose stocks are less than 50% if you want to follow the 4% withdrawal rule). A nice benefit of these funds is that they automatically rebalance for you every year, so you don’t need to do it manually.
Q: Speaking of rebalancing- isn’t it difficult/time consuming/expensive?
A: No. Once a year, you look at how much your money has strayed from your desired allocations. Let’s say you have $100k in your portfolio, and you want $80k in stocks and $20k in bonds. After one year, stocks did well and bonds didn’t, so you have drifted to $85k stocks and $15k bonds. You just want to sell $5k of your stock mutual fund and buy $5k of your bond mutual fund. I made the numbers overly simple but you get the idea. Ever hear of ‘buy low, sell high’? Rebalancing is the mechanism that accomplishes this. If you are in a tax sheltered account, no taxes on the sale. If you aren’t, you’ll pay capital gains tax on just the earnings.
Q: Index funds only provide average returns. Don’t you want to beat the market?
A: No. No one really beats the market consistently over the long term. Many theories and books have shown this. I am happy to take my 7% after inflation long term market average. JL Collins often says to ask yourself the following question: Are you Warren Buffet? No? Than don’t try to beat the market. Not to mention: Actively managed funds cost a fortune in fees.
Compare popular actively managed funds with average expense ratios of 1.5 to Vanguard's total market index fund VTSAX with expense ratio of 0.05. The index fund will save you $1,450 in fees per year, per hundred thousand dollars invested. That’s like an additional 1.45% return! If you think in terms of the 4% rule, this is like saving over a quarter of your annual expenses per year in F.I. Index funds have the lowest expense ratios because they are completely passive and follow a market index.
Q: What’s with the Vanguard exclusivity? Do you work for them? Do you get a kickback recommending their products?
A: No! I recommend them because their funds have the absolute lowest expense ratios in the industry. And they always will because of their unique corporate structure: Vanguard is owned by their own funds, and, as a result, is owned by the investors in those funds. This means that there’s no upper management or shareholders to earn a profit for. They operate at cost and as such, the expense ratios are lower. They also invented and offered the very first index fund in 1975. This was the genius of Jack Bogle.
Don’t have Vanguard available in your 401(k)? Follow this rule of thumb: Choose total market funds that have expense ratios less than 0.25. Simply sort your investment choices by expense ratio, and the cheapest ones will be your index funds. Funny how the best option is also the least expensive? As soon as you quit your job, roll that 401(k) over to an IRA at Vanguard. It’s easy and you can do it entirely online.
Q: What about Betterment, WealthFront, other robo investors, etc.?
A: These are interesting options, but they have higher expense ratios than buying individual index funds. MMM and the Mad Fientist both make the case that Betterment's tax loss harvesting pays for itself, but this also depends on the stage of investing you are in. If you are a high income earner who is already investing in a taxable brokerage, the tax savings may make sense for you. If you are already FI and are in a 0% capital gains bracket, however, you actually want to harvest capital gains, not losses, so you can increase your basis to offset future potential gains. Feel free to explore these options, but if you just want to keep it simple, stick to basic index funds.
Q: Why haven’t you discussed margin, limit, stop, alpha, beta…
A: Because you are not a day trader and don't need to know about them to beat the average investor. Think of the Pareto principle again: you now know more than enough info to be a successful investor. Although there is one more topic we need to discuss…
Leave It Alone!
As an investor pursuing FI, you are in this for the long haul. You want your money to last forever. That means you do not care about the day to day fluctuations of the market, or as JL Collins likes to describe it, the ratio of the beer to the foam. On your journey, over the short term, your investments will lose money. I guarantee it. But over the long term, they will continue to climb upward, providing the engine to the money printing machine that you can leave to your children, should you so choose.
The most important thing you can do for your portfolio, once it is set, is leave it alone. Another huge recession? Leave it alone. Another dot com bust, with stocks dropping 30%+? Leave it alone. Another 2008 real estate bubble burst? LEAVE. IT. ALONE.
It won't be easy. Friends and family will be selling their shares, to ‘get out while they still can'. These same friends will also miss the bulk of the recovery and buy back in too late. They sold low and bought high. They will not be enjoying the 7% return over the long term that you will. You just have to sit back and ride the wave.
Summary
So what's the takeaway today?
1. Max out your tax sheltered buckets first
2. Only keep one or two index funds per bucket
3. Leave your portfolio alone and let it grow!
Sounds simple because it is. Follow these principles and you'll enjoy better returns than the majority of those investing in the market! But what if you want something… even simpler? We'll discuss this and more… on the next Financial 180.
DISCLAIMER!
Where to begin… you can and will lose money in the market in the short term. Past performance does not guarantee future results. Money you invest is never FDIC insured. I am not a tax professional. I am not a certified financial planner. These are simply my opinions and observations after significant reading on the subject and my own investing experiences. However, the advice discussed here is the same advice I give my family and friends, and I stand behind it.
Note that everyone's situation is unique and it is impossible to give the best possible information without discussing the specifics of your situation. This post is generalizing to give the maximum benefit to the largest audience possible. I do not get paid if you choose any of the options discussed in this post. I write this stuff because I am passionate about it (and because I want a place to point friends and family to when they repeatedly ask me for the same advice on these things)!
This is the question that changed everything for me. It’s such a simple question. How many years do you want to work? Most people never think this way. When they do, the popular answers are usually “You work until you are 65” or “You work until you win the lottery”.
Why do we spend so much time thinking about where we want to work, where we want to live, the car we want to drive, and the house we want to live in, but not this more fundamental question?
The trend is pretty dramatic. Save the recommended 10% of your income and you’ll be doing better than the majority of the United States… but you’ll still be on track for a 40 year mandatory sentence. Up your savings rate to 65% and you could be free in less than a decade! The concept behind it is simple: when your annual investment returns cover your expenses, you’re done- you’ve reached financial independence!
But how does this math work? What are the underlying assumptions? And how can it be independent of my salary? As an engineer, I like to fully understand the math behind charts like these before drastically changing my lifestyle.
I decided to search for the underlying equation derivation online, and as it turns out, it isn’t easy to find. MMM discusses the result, but not the actual math. He defers to NetWorthify, which has a great calculator and ‘behind the math‘ page, but their final equation is totally wrong! I turned to Early Retirement Extreme, but even Jacob doesn’t do the full derivation in his book.
For me, this was a “Challenge Accepted” moment! I’ll give you the final equation here, but head to the bottom of the post for the full derivation.
The Early Retirement Equation
Where
n = number of years you have to work before retiring
r = market rate of return, after taxes and inflation
s = annual savings rate
w = annual withdrawal rate
Here it is, the early retirement equation. Plug in an expected market rate of return, a savings rate, and a withdrawal rate, and out pops the total number of years in your working career. Sounds great- but what values should you plug in?
The 4% Rule
The FI community makes the case for a 4% safe withdrawal rate, or SWR, and I agree this is a great starting point for your FI planning. The 4% rule comes from the Trinity Study, which performed a Monte Carlo analysis withdrawing different amounts from portfolios across well over a century of stock market history. The results showed that 96% of the time, a portfolio with a 4% annual withdrawal rate lasted at least 30 years. Those are pretty good odds!
The Mad Fientist wrote an excellent post about how the success of the portfolio is primarily predicted by the volatility in first 10 years of withdrawals, so you’ll want to build in some flexibility in your FI plans if you choose 4% withdrawals. Dropping to a 3% will hedge that volatility, but you’ll have to save quite a bit longer.
Choose a 5% withdrawal rate instead to reach FI quicker, but remember that this requires even more flexibility, particularly if your first 10 years of FI are rough market years. The 4% withdrawal rate, then, is a nice middle ground and is what I’m planning for my retirement withdrawals, so I can be your guinea pig. I’ll document my transition to FI and the flexibility required right here on this blog over the next year to two!
Note that across the internet you’ll stumble upon many articles discussing why the 4% rule is flawed, and why many early retirees will likely fail. While some of the points seem valid, the writers are usually making two invalid assumptions: (1) early retirees will never earn another dime in their 50+ year retirement, and (2) their spending is completely inflexible. These assumptions may be true for traditional retirees, but are ridiculous for most of us in the FIRE community!
The truth is that most FIRE types could pull 5% and still be fine. I’m not planning on sitting in front of my TV and ordering pizzas for the next 50 years. I’m using FI to transition to a lifestyle where I can work on creative and meaningful endeavors without focusing on income. After a few years, many early retirees end up making additional income in FI as a natural side effect of having the freedom to pursue meaningful work on their own terms. I think you’ll find this true of nearly everyone who has reached the milestone and quit their traditional job.
Market Rate vs. Savings Rate
Compound interest is a powerful thing. Numerous articles and even books exist on the topic. But there’s a problem with compounding: It takes a long time to get going! Here in the FI community, we don’t want to wait 20+ years for compounding to work its magic. To retire in ten years or less, the most important number is actually your savings rate.
Let's test this equation out on Wolfram Alpha and chart some results. Assuming a 4% SWR:
Market Rate
Savings Rate
Years Required
8%
80%
5.2
2%
80%
5.9
8%
25%
25.3
8%
10%
38.3
We see that someone withdrawing 4% per year, earning 8% per year in the market, and saving 80% of their money each year can retire in 5.2 years. But what if we change our market rate of return down to only 2%?
In the chart above, our retirement date only pushes forward about 8 months. The market rate of return matters a little for long term wealth preservation, but is practically insignificant during the wealth accumulation phase. What if we put our market rate back to 8% but lower our savings rate to 25% instead?
Ouch- This pushes our retirement date out over 20 years! As you can see, the savings rate has much more impact than the market rate in determining your retirement date. This is good news, too, because unlike the market, your savings rate is completely within your control! Traditional advice is to save 10% of your income. How does that look in the chart above?
40 years?! No thanks. For me, the thought of sitting in a cubicle for 40 years terrifies me. I want to get out and explore the world. I want to go on hour long walks in nature, and still have time for fitness, cooking, and creativity every day. That’s why I advocate for very high savings rates! (See this MMM post for details on exactly how to calculate your current savings rate and net worth, and sign up for Personal Capital to start tracking your net worth over time.)
Summary
The early retirement equation does a great job in showing how your savings rate is the single most important factor in determining how many years are in your working career. Recent college graduates just entering the workforce can use this powerful tool to literally plan how long they’d like to work. For those like myself who have made bad financial decisions for years and need a financial 180, changing your views on lifestyle and spending is difficult. It is almost ‘common knowledge’ that times are always tough, and saving money is always an impossible challenge.
But the truth is that in 1st world countries like the U.S., at almost any income level, you can save 50% of your income if you really want to. Yes, even on a teacher's salary! What it requires is for you to change your thinking about money: Most people think a 2500 square foot home and two to three new cars in the driveway is normal, or worse, something they deserve. Same with eating out at restaurants multiple times per week. When you realize the opportunity costs, you realize these purchases are actually fancy luxuries! Start cooking at home! Sell those new cars! Downsize that new house!
Once you change your thinking, you can challenge other norms as well. Commuting an hour to work? Nope, that's a luxury you can’t afford. Move closer to work. Too expensive? Move to another state. Can't? Change careers. Get creative! There are so many options to increase your savings rate, and the opportunity costs for those dollars are enormous! It's only when you tighten constraints and shut down all these options that the pessimistic complaint of “I could never save 50%” comes true.
OK. You get it. You need to save more. But once you do, where do you put your money so it can grow? CDs? The stock market? The real estate market? All this and more… on the next Financial 180!
Extra Credit: Deriving The Equation
Bonus reading material for those interested! I couldn't find this derivation anywhere else online, so I figure I'm adding some value deriving it here. Let’s start with two equations you may remember from high school: The compound interest equation, and the annuity equation.
Here, a = annual savings in dollars, r = market rate of return, n = number of years, and p = your current savings. Let’s assume our compounding period is annual, to keep the math as concise as possible. We can add the two future values together, because while saving for FI you will be contributing new money to your investments every year (equation 2) while your current savings simultaneously grows (equation 1). This simple equation is equation 3:
Let’s make a key assumption that our expenses in retirement will be the same as our expenses today. This actually bakes in a safety margin because for most folks, expenses go down when they stop working (via reduced transportation, clothing, & outsourcing costs). This gives us equation 4, which states that current expenses (annual income – annual savings) are equal to future expenses (our withdrawal rate in retirement multiplied by the our total future portfolio value). Expressed mathematically:
Where j = annual income, a = annual savings (same as in equation 2), w = withdrawal rate, and F is our Future Portfolio Value from equation 3. We need one final equation so that we can express things in terms of savings rate. This is equation 5, which simply states that savings rate is equal to annual savings divided by annual income.
We now have all the equations we need to solve the big question: how long do you want to work for? To do this, we need to perform some substitution and solve for n. Let’s start by taking equation 4 and re-writing the left hand side in terms of savings rate using equation 5:
Next, plug equation 3 into the right hand side to get:
Next, substitute the FV values from equations 1 and 2:
But we can rewrite annual savings (a) in terms of savings rate (s) using equation 5 again:
Now, we just need to isolate n and perform the natural logarithm to solve. This requires a bit more algebra and is completely procedural… so to save time, let’s copy and paste the following text in to Wolfram Alpha and let it solve for n for us:
j - j s = w p (1 + r)^n + w j s×((1 + r)^n - 1)/r, solve for n
Ignoring the imaginary portion of the result (see assumptions section below), we get equation 6:
Wow! At this point I’m beginning to think Pete’s title ‘Shockingly Simple Math’ is a bit misleading! To test things out, plug the formula into Excel, or let Wolfram Alpha plug in values for us. Try pasting the following:
(ln((j (r (-s) + r + s w))/(w (j s + p r))))/(ln(r + 1)), j=100000, s=.8, p=100000, r=.08, w=.04
And you should get this result: 4.03003. This means you need to work for 4 more years if you have an 80% savings rate, a current portfolio value of $100K, and earn $100K a year, with a market rate of 8% and a withdrawal rate of 4%.
Simplifying the Equation
But didn’t we say we could calculate all of this using savings rate instead of salary? We can, if we assume we are starting from $0 and eliminate p from the equation. Let’s go back to simplification step 4 and set p=0:
Now let’s move j*s over to the right hand side…
…then divide both sides by j:
Sweet! We were able to remove both p and j completely from the equation. Solving for n back on Wolfram Alpha and doing one final simplification gives us a formula that should look familiar:
There it is! The Early Retirement Equation. It is a bit easier to digest in comparison to equation 6 above. Taking it further, an interesting thing happens if we bake in a safe withdrawal rate of 4% and a market return rate after inflation of 8%:
Use this handy one variable FIRE equation to impress your friends!*
Assumptions
Solution for n is over the reals
n, j, s, p, r, w are > 0
Withdrawal rate should be less than market return
Current annual expenses are equal to annual expenses in retirement
You want the money to last forever, so no drawing down of principal
Annual income is after taxes
Rate of market return is after taxes and inflation
Interest is compounded annually
Behind the Equation
Now that you understand the equation, you can plug in numbers to recreate your favorite graphs. JL Collins uses this chart from Darrow Kirkpatrick’s book ‘Retiring Sooner‘:
By plugging into equation 6 above, we can now confirm they assumed a 4% SWR and an 8% market rate of return.
MMM references this handy graph from NetWorthify, which assumes a more conservative 5% market return with the same 4% SWR:
Jacob from ERE takes things a step further and graphs the retirement date curves for multiple rates of return:
If you've read this far, you must be as passionate about this stuff as I am… Cheers!
*This will probably only impress your really cool friends.
In our last few posts, we discussed our financial 180, and our strategies for saving money on food, shopping, and monthly recurring bills. So far, we’ve shown how we uncovered $3000 per month, and used that cash flow to douse the fire on our mortgage from hell. But even with these extra principal payments, the mortgage payoff seemed to be taking forever! We wanted to have the house paid off in under two years, and to do so, we needed to free up more cash flow every month. Let's look again at our annual expense and see if we can really get our savings snowball rolling.
Travel
Travel was a straightforward category to cut: we just had to stop traveling so damn much! Before our financial 180, we would often travel out of state once per month or more. But these weren’t leisure trips. They were guilt trips. With no kids and good salaries, most of our friends insisted we fly out to visit them every time. Our town was smaller and less interesting anyway, or so they’d say.
And fly out we did. Our work schedules gave us every other Friday off in exchange for longer (9+ hour) work days, so nearly every other weekend was spent in an airport. We didn’t know about travel hacking at the time, so our tickets were often purchased at full price, on a whim a few days before traveling. This is not an affordable way to travel!
After a few years, we realized this type of routine travel is actually a chore. We dreaded the airport lines. We hated spending two days of a three day weekend in transit. And we hated the stress of coming home a few hours before work on Monday, with no time to cook, clean, or even take care of ourselves. I was spread too thin, and paying hard earned money for that stress.
Reducing our travel was a relief. We knew we needed more time for cooking and household maintenance, so cutting back was a win-win. If people really want to see us, they can come visit. We have a guest room waiting. Cutting back on travel saved us over $10K per year. It also greatly reduced our stress levels, and gave us time to practice cooking!
Note that we didn't eliminate travel completely: we still budget for and enjoy slower, more relaxed travel. Instead, we cut the weekend obligatory trips to see out of state friends and extended family that never returned the favor.
Automotive
The biggest improvements we made in the automotive department were paying off our car loan in full, and becoming a one car household. This cut our gasoline expenses, and removed redundant registration, insurance, and interest costs. But this was only the beginning. Motivated to pay down our mortgage quickly, we decided to reduce our driving in general.
Instead of taking weekly 100 mile round trips to Orlando to visit Swedish furniture stores, we stayed local and looked to Craigslist and thrift shops for our furniture needs. Instead of driving to the next county to eat at the popular 4 star restaurants, we discovered a few hidden gems right in our own neighborhood. When possible, we began biking to nearby shopping centers for errands. We also started walking to the parks and library in our neighborhood, instead of driving, and the savings really began to snowball.
Gifts
Gifts are one of those areas where you need to tread carefully and make changes slowly. Every family and friend network is unique. Our strategy was to gradually go from being that couple that gave pricey, fancy birthday and holiday gifts, to being the couple that gives thoughtful homemade gifts or meals. For many people, delicious fresh baked cookies and a thoughtful card are probably preferable to yet another plastic gizmo or kitchen gadget, but know your recipients.
For the most part this strategy worked well for us, but again, this is a delicate subject for many people so move slowly. We still enjoy taking family out to dinner to celebrate special occasions. The trick is ensuring the frequency is once or twice per year, not once or twice per month! At our worst, every weekend had become a celebration for someone or something, and we were buying someone a drink or a meal on a weekly basis. This had to be phased out, and over time, we were able to reduce the amount we spent on this category by two-thirds!
Miscellaneous
Ah, the miscellaneous category. The area of Personal Capital where everything is conveniently swept under the rug! We knew if we were going to get serious paying off our mortgage, we needed to tidy up all areas of the budget, and the ‘misc' area was ripe with opportunity.
Entertainment made up a large portion of our miscellaneous spending, so we got out the red marker and started circling unnecessary luxury items on our monthly statements. What did we find? Weekly trips to the movie theater (complete with over priced theater refreshments), an XM radio subscription, and expensive season tickets to Broadway style shows.
These costs add up, so we cut them and replaced them with free or cheap alternatives. Redbox movies are only $1 a day, and pair well with home cooking for date night. Pandora and Slacker radio work well in place of XM. And instead of buying season tickets to shows in the big city 50+ miles away, we started buying tickets to local playhouses once or twice a year instead of once or twice a month. This has the added benefit of making these events feel more special!
Convenience and luxury was another problem area for us. We found tons of ATM fees, huge monthly dry cleaning bills, monthly spa packages and massages, fancy and unnecessarily expensive tax prep software, and additional credit cards with annual fees. While super expensive, items like these are easy to fix if you just tackle them one at a time. We stopped going to ATMs that charged fees. I changed my work wardrobe to one that didn't require dry cleaning. We did some research and learned to give each other better massages at home for free!
Hard Work Pays (The Mortgage)
These things really add up. Within a few months, our savings snowball had increased past $5000 per month, and kept growing. We used that cash fire hose and paid off our mortgage in under two years!
Once the mortgage was paid off, there were no required monthly principal and interest payments, and the snowball grew even faster. We were also able to lower our homeowners insurance coverage and increase the deductible higher than what the terms of our original mortgage would allow. This saved us even more. By 2015, our savings rate had surpassed 80%.
But what is the significance of savings rate anyway? And how did we use this savings snowball to accelerate towards financial independence? All this and more… on the next Financial 180.
The world of real estate was a strange place in July of 2007. I think at this point, mortgage lenders had an idea of what was about to go down, but still kept writing as many toxic loans as possible before their inevitable doom. Our first home purchase was one of these loans!
As college students with no jobs and $300 in total savings, our friendly mortgage assistant recommended 100% financing with two mortgages: an 80% and a 20%. He also recommended interest only ARMs for these mortgages, because it would help lower our monthly rate. Sounded great to us! The 80% had a 6.5% interest rate, and the 20% had a 12.5% interest rate. For those of you who know real estate, you can see how dangerous these loans were.
But we were only kids, with no actual money, surprised that someone would give us a house. I remember walking away from the closing with house keys, an $8K incentive check from the builder, and a grin on my face. Looking back, this was probably the perfect example of predatory lending, but I can’t blame them entirely. I could have done more homework. Or at least rented for a year or two to learn the area and save up a down payment.
After the closing, we went to the store and purchased some paper plates, plastic cutlery, a $3K HDTV, and a PlayStation 3. Like I said before: we were still kids. We ordered pizzas and spent 2 nights on an air mattress in the new house, then drove 3 hours back to campus to finish our final semester of school. We then drove back and forth every other weekend to check the mail. If there was ever an anti-mustachian way to do real estate, this was it.
A Cash Flow Killer
What did our mortgage breakdown look like?
Each month, we would pay $1,614.96, of which $1,220.96 went to interest, $246 went to taxes and insurance (T&I), $148 went to our homeowners association (HOA), and exactly $0 went to principal. We assumed we would start paying more principal eventually, but years later, we still owed the same $170K on a house that was now only worth about $70K. The house had dropped a full $100K in value after the financial crash. This was not good.
We were paying ~$20K a year into this house, and not a drop of it was principal. This is crazy! Let's do some math and run our numbers through an amortization calculator. Our total mortgage principal was $168,990.00. But if we actually paid this loan off over the course of 30 years, we need to add $270,555.60 in interest payments, for a total cost of $439,545.60. It's like purchasing three houses, but you only get to keep one!
An Exit Strategy
Buying more house than you can afford and paying interest on it for 30 years eats up cash flow that could otherwise be used for paying down debt or investing. That $270K in interest payments over 30 years could be sitting in my investment account instead! That's why I have a hard time swallowing the traditional advice that mortgage debt is ‘good debt'. To me, debt is debt and interest is interest. We decided we were done being on the wrong side of the interest equation. But how could we get out?
We couldn't sell it- the property value was too low compared to the mortgage, and we still needed somewhere to live. Refinancing wasn't an option- our loan to value ratio (LTV) was so high (over 240%) we didn't qualify for the various HARP (Home Affordability Refinance) programs of the time. We are not the type of people to walk away from financial obligations, either: we signed our names on the dotted line, so it was our responsibility. We decided we needed to buckle down and pay it off aggressively.
Around the bottom of the real estate market, an opportunity arose for us to move in with a family member. The situation wasn't ideal: it was located in an older part of town, the neighborhood seemed a bit sketchy, and sharing a house with parents is a true test of patience. But we took the opportunity and rented out our house for additional income. The rental income was still $700/mo short of covering the mortgage, but it was better than nothing! We added it to our snowball and began quickly paying down the loan.
Think Before Buying
What did I learn from our mortgage crisis?
Don't buy ‘more house' just because you can
Buy with cash, or put a large down payment
Pay it off fast- like you would any other debt
If you live in a high cost of living area, rent instead!
But what if you were lucky enough to lock in a low 3% interest mortgage for 30 years? Should you invest your cash flow instead of paying off your mortgage? This is a tricky subject, and there are so many discussions on this. The traditional advice is that you could invest your money and make more than you could paying off the mortgage.
Personally, I would still choose to pay off the mortgage instead. You enjoy a guaranteed rate of return, and if you pay it quickly, you'll then have a much larger cash flow to invest following your payoff. To me, having a paid off house in FI is the safer solution, but I am somewhat risk averse and this is just my personal preference.
Millennial Revolution blogs about how mortgages destroy wealth and are the primary reason most people never become millionaires. They are adamant about renting instead of owning, and for the most part, their argument makes sense when you run the math.
There are exceptions, however. In certain low cost of living areas, owning can save you money over renting. Some back of the napkin math: Following the 4% rule, you need $300,000.00 invested to support a $1000.00 monthly rent payment passively forever. If you can find a house whose total cost (including interest, taxes, insurance, HOA, and maintenance allowance) is less than that, it can be a better deal. But these properties are usually the exception, not the rule.
Wrapping It Up
I happen to live in one of the areas where owning can save money over renting, but it requires buying the right property at the right time. Rental real estate can also make you good passive income, if the property is chosen carefully and the math works out. Our property was unfortunately not one of those.
So we paid it down aggressively. Adding the rental income to our savings snowball, we now had over $3000 a month to douse the mortgage fire. But even at this rate it still felt like we were moving in slow motion. We wanted to have the house paid off in under two years, and to do so, we needed to find an additional $2000 a month. We were motivated and ready to make more drastic cuts to our spending… on the next Financial 180!