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September 26, 2000

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Subject:  How To Retire Early--In 25 Words
Author:  Hocus

Ignore advice to save 10 percent of your pay, and don't assume that your spending in retirement will be 80 percent of your current income.

Those are the 25 words that workers need to know if they are to retire early. For those who never hear these words, retiring early will not just be hard--it will be close to impossible. Each year that a worker follows the conventional advice, his prospects for early retirement grow more and more distant. That's not just my opinion--it's mathematics.

Say that you can count on a 4 percent real rate of return (or safe withdrawal rate) on investments after retiring. That means that, once you have saved 25 times your annual spending, you are no longer dependent on a paycheck to support your lifestyle. The average worker starts working full-time somewhere near age 20 and stops somewhere near age 65. So he has about 45 years to acquire the 25 times annual spending needed for financial independence.

In order to retire at age 65, he should be saving 1/45th of the total amount needed each year. If he wants to retire early, he needs to do better than that. For example, if he wants to retire at age 45, he needs to be putting aside each year 1/25th of the total capital needed.

The worker earning $50,000 would need to save 25 times $40,000--that's $1 million--to satisfy the "80 percent of income" rule. To stay on track toward meeting that goal in 45 years, he would need to save $22,222 per year. But the "10 percent of pay" savings rule calls for only $5,000 in savings each year. So the worker following the conventional formulas falls more than $17,000 farther behind each year he works.

It's not clear to me that the "80 percent of income" rule and the "10 percent of pay" rule will even provide for a safe retirement at age 65. It's possible that the compounding of earnings on the savings (which I have not included in these calculations), would make up the difference. But because most workers earn relatively low incomes in their early working years, saving 10 percent does not allow for compounding to play much of a role until hope for a significantly early retirement is gone. It takes decades to gain much traction under the conventional rules of thumb.

Perhaps it's not so surprising that an average-income worker cannot hope for early retirement employing the two standards of conventional personal finance advice. The conventional advice was designed for the sake of those seeking a standard age-65 retirement. What is more remarkable is that the conventional advice dooms even those being paid incomes far above the average.

A worker earning $200,000 would need $160,000 a year to live on in retirement, pursuant to the "80 percent of income" rule. So he needs to save 25 times that amount, or $4 million. Each year that he saves more than 1/45th of that amount--or $88,888--he is making progress toward a age-65 retirement, and each year he does better than that he is making progress toward a Retire Early goal.

But the "10 percent of pay" savings rule calls for only $20,000 of savings per year. So the worker earning $200,000 is falling farther behind each year than the worker earning $50,000. Instead of undershooting the mark each year by $17,000, the more highly paid worker is undershooting by almost $70,000.

There are factors that come into play in financing a retirement not considered in these calculations. My purpose here, though, is not to offer a precise account of how retirement are financed. It's to outline the general course of financial planning followed by most workers, and to thereby come to understand better why most workers don't strive to achieve financial independence.

Many workers accept the conventional rules-of-thumb as reasonable guides to financial planning. Once they do so, they have constructed a major obstacle to their awareness of the possibilities. Use of the conventional rules creates such a large gap between savings accumulated and savings required (and causes the gap to increase by such large amounts each year), that it generates a growing feeling of hopelessness.

Even workers who do not devote a great deal of attention to their finances have a vague sense of how much they have saved and how much they would need to retire. They don't know the details, but they know the two numbers are far, far apart and that the distance is not being diminished much with the passing years. That's why retiring early seems impossible. I suspect that this phenomenon is also a big part of the reason why the subject of financial independence often causes discomfort and opposition.

All workers would want to know about Retire Early ideas if it were possible to apply them in their own circumstances. However, workers following the conventional rules have become convinced by the insignificant progress they have made on their own financial independence that the ideas are not applicable to them.

The two conventional rules are the premises behind many workers' financial thinking. Discussions not proceeding from these premises do not seem to "fit" to them, do not seem to be connected to the few things about personal finance that they already "know." The premises are repeated so often, and accepted by many workers so early in life, that belief in their reasonableness runs deep. So it is the liberating but unsettling ideas that are often rejected, not the limiting but familiar ones.

It's the combined effect of the two conventional rules that is particularly damaging to efforts to develop a sound lifetime financial plan. With each increase in income, the conventional advice pushes up the amount needed to satisfy the retirement spending target (1/45th of income x 25) to a greater extent (in dollars) than it pushes up the annual savings target.

The result is that workers who receive increases in pay as they gain experience do not get closer to financial independence, but lose ground. If a worker who follows the conventional rules wants to retire early, he would be well advised to turn down any big pay increases. A worker who has faithfully saved 10 percent of income all his life will find that accepting a promotion will throw his on-track savings plan off course.

He has been saving 10 percent of the lower pay figure, assuming retirement needs in line with the lower income. The new income expands those needs considerably, and it may take a few years for him to make up the ground lost (under a formula in which retirement needs are tied to income, not spending) by earning more.

Carried to their logical conclusions, then, the two conventional rules require a worker to sabotage his efforts to make financial progress. In reality, no worker is so obsessed with the implications of the two rules of thumb that he would turn down a pay increase. I am convinced, though, that, in more subtle ways, the result of the two rules is indeed self-sabotage. The worker doesn't turn down the pay increase. But he looks for things to do with it that sacrifice the opportunity for early financial independence.

Most of us have been happy at different times of our lives at different spending levels. We have a desire to spend more, but restrain the desire to satisfy a conflicting desire to handle our financial affairs responsibly. Rules of thumb suggesting that it would be reasonable to spend more offer permission to direct our energies toward fulfillment of the former desire. It's a permission we are happy to act on if we don't think through the consequences too carefully.

Thus, the way of thought that follows from acceptance of the two conventional rules causes many workers to lose the opportunity for early retirement that comes with pay increases.This happens not because they have calculated that more spending will bring more happiness, but because the conventional rules send a message that to increase spending is the normal, reasonable thing to do.

Those who advocate early retirement and those who reject the idea as impossible are living in two different worlds of thought following from two different sets of premises. Those who live in the world of conventional advice think that those who talk of retiring early must not be disclosing everything about their circumstances--they must be earning huge incomes, having extraordinary luck in the stock market, electing not to have children, or receiving large inheritances. It seems from this point of view that there must be some "trick" to retiring early.

Any of those factors might play a role. But the effect of any of them is likely to be small compared to the effect of following the conventional saving and spending rules. Those rules have a far greater effect over time because they come into play each and every year that a worker earns money from employment.

The key is turned when a worker takes to heart the 24 words: Ignore advice to save 10 percent of your pay, and don't assume that your spending in retirement will be 80 percent of your working income.


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