As a young adult, I had only a vague notion of retirement. I thought if you worked your entire career, you would one day reach the age where you would be eligible for Social Security and live out your golden years sitting poolside or playing golf. I'm not sure where this impression came from, but the idea of planning for a retirement of anything beyond that was definitely a foreign concept. Truth be told, I naively never gave it much thought because it always seemed so far off; after all, who had time to think about retirement when there were so many other, much more pressing needs?
Fortunately, as I entered the workforce, my mental picture began to slowly mature, and I was fortunate enough to take a job with a pension. I still believed I would have to work a full career, but that I would be able to live a much more comfortable retirement with both my pension and Social Security checks supporting me.
It wasn't until years later that my understanding of retirement graduated from this simplistic notion. When I first joined Motley Fool I was amazed by some of the stories on the discussion boards of wildly successful investment careers that transformed some average Americans' retirement years from mundane to profound. I also began to read inspiring tales of those who'd bucked our culture's consumer-driven mindset for a life of frugality and freedom from traditional 9-to-5 jobs, such as this one from my fellow Foolish contributor Brian Stoffel. Stoffel and his wife quit their teaching jobs and now split their time between his native Wisconsin and a coffee farm in Costa Rica.
As I researched further, I discovered there was a burgeoning movement of young professionals who were forgoing the traditional route to retirement. The movement is known as FIRE, an acronym that stands for "financial independence, retire early."
What is FIRE?
The FIRE movement defines "retirement" a bit differently than mainstream culture. While there's no single authoritative source, this definition from Mr. Money Mustache, a well-known early-retirement blogger, probably best catches the spirit of the FIRE mentality:
Retirement is earning the privilege of being free to enjoy the balanced lifestyle of our dreams, without "working for a living" getting in the way too much. You don't have to quit working altogether, you just have to feel secure enough to be choosy about your work, and your schedule.
In other words, FIRE is not meant as a means to retire to the golf course by the time you reach 40, but more as an escape from dependence on a traditional full-time job. For instance, Mr. Money Mustache and his wife quit their day jobs as software engineers, but own rental property and actively blog to supplement their income. The point is that they're not married to a desk job or a corporate culture. A scan of the early-retirement community shows more of the same. While many early retirees live entirely off investment income, others have found income streams ranging from part-time jobs they love to entrepreneurial ventures that take up little time.
How is early retirement possible? Introducing the 4% rule...
How can someone in their 40s simply quit their job and retire? Actually, the math is pretty simple if you're familiar with the 4% rule. While far from perfect, the 4% rule is a good rule of thumb when determining how much money you can safely withdraw during retirement without running out of money before you die. In the 1990s, financial advisor William Bengen studied stock and bond returns over a 50-year period and concluded that withdrawing 4% annually would allow retirees to live off their nest egg safely for at least 30 years, regardless of market conditions.
Here's how to apply the 4% rule: Calculate your expected annual expenses during retirement and multiply that figure by 25. The answer is the savings you need before you can retire and safely withdraw your annual expenses. For instance, let's say you calculate that you can cover the quality of life you desire in retirement with about $40,000 per year. The nest egg you will need, then, in order to retire is $1 million. The math looks like this:
40,000 * 25 = 1,000,000
This rule is designed for portfolios consisting of a stocks-to-bonds mix ranging from 50-50 to 60-40. The rule also allows you to adjust your annual withdrawals to allow for inflation.
However, depending on your portfolio's asset allocation, this apprach might ultimately prove to be too conservative or too generous.
Here's the rub with the 4% rule
When Bengen released his study, the clients he was serving were aiming for retiring at more traditional retirement ages -- much later in life than the aspiring early retirees of the FIRE movement. Early retirees will need a portfolio to last much longer than 30 years. While Bengen observed that the portfolios would last for at least 50 years in the vast majority of the rolling periods he examined, some lasted for as little as 33 years. Based on historical returns, this means there is certainly a risk that early retirees will exhaust their portfolio before the end of their lives.
This creates a problem for early retirees. One thing early retirees can do is use a more conservative 3% withdrawal rate. Using this withdrawal rate, 100% of the portfolios from the rolling periods Bengen examined lasted at least 50 years. Many lasted into perpetuity. Other strategies early retirees have discussed include finding seasonal or part-time work at different periods in retirement, or starting off with a nest egg greater than the targeted amount.
It should also be noted that the rule doesn't take into account factors such as major medical expenses, emergencies, and historically low bond yields. That said, the 4% rule gives you a good idea what your net worth needs to be before you give your boss a two weeks' notice.
Play offense and defense to realize financial independence
While the math is easy, the actual execution of saving $1 million, give or take, is a lot harder. Most early retirees spend their working careers with savings rates of well over 50%. That means a family making $59,039, the median American household income in 2016, would have to save at least $29,520 to match that rate. In an age when 41% of Americans cannot even come up with $400 to cover an emergency, saving over 50% of your income requires some serious countercultural tendencies.
Simply stated, the only way retirees can accomplish this seemingly Herculean task is to employ equally aggressive offensive (earning more money) and defensive (cutting spending) measures. The greater the gap between what savers earn and what they spend, the more money that can be squirreled away into their investment and savings accounts.
Earning more money makes this process easier, as it allows you to increase your savings rate without resorting to Draconian spending habits. Some people accomplish this by pursuing higher-income careers -- some of which don't even require a four-year college degree! -- or finding a side hustle. Others turn to more passive income streams to increase their savings, such as renting properties or selling stuff online. Whatever you choose, it's important to maximize your earnings if early retirement is a goal.
Cutting spending accomplishes two simultaneous goals for aspiring early retirees. In the most obvious way, every unspent dollar is an extra dollar saved. For instance, if you cut out a $5 weekly coffee habit, that's $5 extra every week that goes toward savings. Yet it also brings down your annual expenses, making the final net worth that needs to be reached a little bit smaller. For these purposes, cutting a $50 monthly expense means you require $600 less in yearly spending. Multiply that number by 25 (using the 4% rule discussed earlier), and that's $15,000 less that you need to save in order to retire. Do this seven times and that nest egg you need is suddenly over $100,000 smaller. As you can see, cutting out just a few $50 monthly expenses can quickly add up.
Before we cover some of these offense and defense techniques in more detail, there's one more thing we need to discuss.
Know thine enemy: Budget!
Incredibly, less than half of American adults either know where their money is going or bother to track their spending, according to a 2018 Consumer Financial Literacy survey. Before you can begin to trim the fat in your expenses or look for extra ways to boost your income, there's one thing you absolutely must do first: establish and stick to a budget. For sticking to long-term goals, ensuring that your spending reflects your values, and finding ways to save more money, there is no substitute for a good budget. It doesn't have to be a daunting process: There are several apps and programs that make budgeting and money monitoring easier than ever, including Mint, YNAB, and Dollarbird. The Motley Fool's own budget calculator also helps you take a big-picture view of where your money is going.
Still, if technology is not for you, a pencil and calculator or Excel spreadsheet would work just fine. The important thing is to establish specific and concrete goals, set realistic expectations, and automate your savings. Still not sure where to start? Check out this guide by fellow Motley Fool contributor Christy Bieber, who thoroughly covers all the bases for budget rookies.
Play defense: Cut spending and save more money
Everyone has spending habits, such as eating out for lunch, that can be cut back. However, while I'm a fan of finding those small savings hacks that can lead to big savings, to save more than 50% of your income you're going to have to think bigger. Here are some common techniques early retirees employ in the big budget categories to squeeze every last dollar out of their income:
Housing: Unsurprisingly, housing is the top expense for most American households, and many U.S. families have fallen victim to buying more house than they can easily afford. Those who aspire to FIRE, however, look for hacks to keep this line item in check. One common technique is to purchase a duplex or triplex; then, while living in one unit, they rent out the others for additional income, essentially driving their housing expenses down to zero. For those skilled in the art of home improvement, another common strategy is to buy a fixer-upper cheaply and do the bulk of the handiwork necessary to improve the house.
Of course, there's no one answer that fits all. For instance, some might find it best to live close to their job to save on transportation costs. Those who work in high-cost urban areas might find it makes the best sense to move farther away from their work to find cheaper housing. Those who have the luxury of working remotely or from home might want to explore other parts of the country where they might want to live. The important thing is to realize that there might be better alternatives than where you are living now, and to see if those options make sense to you and your family.
Transportation: Another huge budget line item for most Americans is transportation. This includes everything from car payments and insurance to vehicle maintenance and gas. After adding up all your expenses, you could find that you're paying more for your car than you realize. As mentioned above, many savers like to find a place to live that's close to where they work in order to keep mileage low. Depending on your situation, it might even make sense to lease cars instead of purchasing them. Most important, however, might be to buy used cars instead of new ones.
Taxes: The Beatles sang "you're working for no one but" the taxman, and there are times when that certainly seems to be the case. So it's important to take advantage of any breaks the government allows, including putting as much money as you can in tax-advantaged accounts, as opposed to taxable accounts. There are five primary types of savings accounts that afford the American taxpayer huge savings.
- The 401(k) is a defined-contribution account offered by most U.S.-based employers.
- IRAs, or individual retirement accounts, come in two flavors: the traditional IRA and the Roth IRA. Traditional IRAs are funded with pre-tax income, meaning contributions will be tax-deductible in the same tax year. Roth IRAs are funded with after-tax dollars, but withdrawals are tax-free.
- A 529 is a college-savings plan funded with after-tax money, but your investments can grow -- and returns can be withdrawn -- tax-free. Of course, penalties will be tacked on if the funds are not used for qualified educational expenses.
- Finally, health savings accounts (HSAs) and flexible savings accounts (FSAs) are ways to take further advantage of tax breaks while saving for future healthcare costs. Of course, since both of these accounts come with lots of expenses, be sure to carefully review the rules and qualifications that come with each.
Healthcare: One of the biggest challenges early retirees face is how to pay for health insurance before they are eligible for Medicare (usually at the age of 65). First, it should be noted that employees who lose their jobs, even when they resign, can be eligible to keep their health insurance up to 18 months after their termination of employment under the Consolidated Omnibus Budget Reconciliation Act, better known as COBRA. COBRA applies to most employers with at least 20 full-time employees. To be eligible, the former employee must pay the entire cost of the healthcare plan to their former employer, which can be expensive, but still sometimes cheaper than other options.
After the COBRA benefits expire, health insurance options are limited for early retirees. The most obvious choice is shopping for a plan on the Obamacare exchanges. Unfortunately, the area where you live will largely determine the quality and cost of your choices -- just another reason to choose where you live post-retirement carefully.
Another option growing in popularity is enrolling in healthcare sharing ministries. These are organizations that share the cost of healthcare among a large group of individuals that share common religious beliefs. There are numerous pros and cons to such groups, including lower costs than most healthcare plans but also restrictions on what's covered, that should be carefully studied before subscribing to such a plan. These organizations are exempt from many of the regulations governing health insurance due to their religious nature.
Other spending hacks: Once you create a budget, you will undoubtedly find other ways to attack your expenses, especially if you get creative. Many savvy consumers find ways to exploit credit card rewards for things such as travel or just to get cash back. For instance, we exclusively use cash back cards to fund our Christmas gift purchasing every year.
Play offense: Earn more money
Just as important as playing defense (stemming expenses) is playing offense -- increasing the income streams going into your bank account. What helps the most in this space is to either focus on a career with a high salary or to pick up a part-time job as a side gig. If you're young enough, probably your best bet is to choose a valuable college major -- and avoid a less valuable one. If you're past college age, think about earning certifications in your chosen profession, or even switching into a higher-paying field if the barriers to entry are not too high. Whether you're thinking about switching careers or moving up the ladder with your current employer, some things are always helpful, such as writing a killer resume and networking.
Thanks to technology, it's easier than ever to find a side hustle, a part-time job to supplement your income. From driving for Uber or Lyft to selling your skills for quick, low-paying jobs on platforms such as Fiverr, technology has opened up a whole new gig economy. When searching for a side gig, prioritize what attributes you would like the most, from flexible hours and room for growth to finding ways to monetize an enjoyable activity. Even better, it might be possible to turn a hobby into an income-paying venture, which is essentially the path I chose, turning a love for investing in stock into a freelance writing position.
One final note: While it's easier than ever to earn income from home, be sure to watch out for scams. Vet your choices carefully and be especially wary if a potential employer asks you to pay money up front.
Invest the difference
Almost as important as saving half your income is knowing what to do with it beyond simply not spending it. You certainly don't want to stuff all that money under your mattress or into a savings account. Assuming all your debts are paid off, here are a few good rules of thumb on where to put your money.
Besides cash options, investors might want to consider bonds as a means to invest money that might be needed within two to four years. Bonds are debt instruments used to raise capital by corporations, municipalities, and government entities. They can be used to raise money for all types of projects, such as a corporation needing to build a new factory or a municipality wanting to build a park. Bond issuers pay the investors for a predetermined length of time at a set interest rate. When bonds mature, the principal is returned to the investor.
There are several distinctions to be aware of when investing in bonds. For instance, municipal bonds offer lower yields but come with certain tax advantages. Bond ratings disclose how likely it is for a bond issuer to default on its payments before the bond matures. Bonds with lower ratings indicate the bonds are riskier than bonds with higher ratings, but also come with a higher yield. If you are interested in learning more about bonds, I highly recommend you read my Motley Fool colleague Maurie Backman's much more thorough treatment of the subject.
While cash and bond assets certainly have a place in a diversified portfolio, if you're still saving for retirement, the majority of your savings should be going into the stock market, which historically has achieved the highest returns. This is money that you do not intend to use for at least five years.
Low-fee index funds are a wonderful investing tool
The vast majority of investors aiming for an early retirement advocate investing in low-fee index funds, funds designed to track a specific stock index. The chief reason index fund investing is so popular with the early-retiree set is the fact that, since they are designed to only track a specific index, they require little active management. This gives them a much lower cost than mutual funds that require active management. This one key advantage consistently translates to greater returns when compared to their mutual fund counterparts. More than 88% of large-cap mutual fund managers failed to beat the S&P 500 index over a five-year trailing period, according to a 2017 study conducted by S&P Global.
David and Tom Gardner bless passive index investing in the third edition of their book The Motley Fool Investment Guide:
With passively managed funds, you get one-stop diversified market exposure, lower fees, zero research commitment, a full knowledge of what investments the fund is making (typically market-weighted long positions in a number of well-known stocks), and -- not to be underrated -- time to spend on other things. All things considered, how Foolish can you get?
(Important note: In Motley Fooldom, when "Foolish" is capitalized, it is meant as a compliment.)
For investors with neither the time nor the interest to pay attention to their investments, low-fee index investing is probably the ideal choice to capture the outsize returns of the stock market. That said, for investors with a high interest and spare time that can be spent studying investments, I would be remiss to suggest that it was not possible to beat the market by studying individual stocks and creating a customized and diversified portfolio. Unfortunately, I have found several personal finance sites and blogs trumpet the exact opposite message: Beating the market is impossible, so don't you dare try!
There are voices in the wilderness preaching the values of fundamental stock analysis. The Motley Fool, for instance, offers several resources for individual investors. Consider the following example to illustrate how much quicker you can achieve savings if your rate of return is increased by just a few percentage points. Let's say, going forward, you're able to save $1,000 per month, and you start with $10,000 in savings. Here's how long it would take you to reach $1 million at different rates of return before taxes and inflation:
|Rate of Return||Years to Reach $1 Million|
Many who warn individual investors away from trying to beat the market cite the efficient market hypothesis, which holds that all information is perfectly priced into stocks at all times. The primary implication of this theory is that beating a stock market index is simply a matter of luck, not skill or careful research. Yet, when put under close scrutiny, the theory hardly holds up.
Consider how the S&P 500 index, probably the most closely followed index in the entire world, has performed in my adult lifetime. From 1997 to 2000, the index doubled, only to return to its starting value by the summer of 2002. The index doubled once again by the end of 2007, only to give back the entirety of its gains in the financial crisis. In March 2009, the index was valued lower than it had been in 1997, a whole 12 years prior! From that time on, however, the index has tripled in value. This hardly looks like an efficiently valued index!
Investors have successfully pursued several different strategies to beat the market, from value to growth investing. If investing is an interest for you, just know that several investors have been able to boost their returns by carefully constructing a stock portfolio rather than passively investing in index funds.
The why of FI
Ultimately, it's important to remember that early retirement is not for everyone. There are many people who love their jobs and find purpose and direction from their chosen callings. That said, many valuable lessons can be gleaned from the preparations early retirees take during their working years. Building up your savings and lowering your monthly expenses increases your financial fortitude, making it much more likely you'll be able to withstand a disaster or medical emergency, as well as giving you more options in the future. Just because you love your job now doesn't mean that will always be the case, especially if you get a new boss or your company comes under new management.
Finally, it's important to remember that money isn't an end, only a tool to reach that end. The end might be different for everyone. For some, it might mean longer vacations with their family or putting their kids through college. Early retirement offers freedom from a 9-to-5 job and from financial dependence on an employer. It's essential to understand what your "why" is, or else you might find that you'll never have enough. Stoffel wrote that quitting his teaching job and moving to Costa Rica was about finding "the only way to get off the hedonic treadmill and focus on what really matters in life."
Contentment ultimately comes from much more important things in life. Money is just one of the tools you can use to get there.
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