Impact of Savings Rate on Achieving Financial Independence and Retiring Early

IMPORTANT NOTE: This is written with my sons JC and Timmy as the intended readers.

Previously, I had mentioned that any money that you spend on personal expenses is money that you can’t use to buy back your free time by investing in your financial capital bucket. I’d like to continue discussing this with a series of related examples.

I’d like you to imagine for a moment that you’ve decided to do what many financial advisers suggest and that you save 10% of your income and invest it in stocks. You decide to enjoy the remaining 90% of your income and use that to fund your current lifestyle.

In your case, you are earning about $70,000 per year ($5,833.33 per month), so that means you’re saving $7,000 per year and living on the remaining $63,000. Furthermore, since you’re currently enjoying the lifestyle that $63,000 per year can buy you, I am going to also assume that when you retire, you’d like your investments to provide you the same $63,000 so you can maintain the same lifestyle in retirement. There is some data to suggest that your expenses tend to go down slightly once you enter retirement, but there is some question as to whether this is buy choice or necessity. I’d rather plan for you to sustain your current lifestyle and if you choose to live at a lower standard of living, that will be up to you to decide at that future time.

I am going to call an investing plan or strategy a Scenario. For the Real Estate Financial Planner™ software we call Scenarios a group of Accounts, Properties and Rules that describe an investing plan.

State and Federal Income Tax

In this Scenario, you’re going to be earning $70,000 at the start and saving $7,000 of it each year. But, we need to estimate what dollar amount and ultimately what percent of your income will be consumed in federal and state income tax.

JC’s Estimated 2018 Income Tax at $70K Annually

By visiting a tax estimating website, we are able to get an idea of what a single male earning about $70,000 per year with just himself as an exemption will pay in both state and federal income tax. It looks like you’re going to be paying about $14,054.50 in federal income tax and about $3,419.25 in state income tax. That means you’re paying a total of $17,473.75 in income tax or about 24.96% of your income in income tax. We need the percentage since the Real Estate Financial Planner™ software asks you for a percent of your income as your tax rate.

Let’s walk through the math together. You’re earning $70,000 and paying 24.96% or $17,473.75 in state and federal income tax. You have $52,526.25 per year left over before your savings. If you decide to save $7,000 per year, then you need to live on $45,526.25 per year. That’s about $3,793.85 per month.

Target Monthly Income in Retirement

For this particular Scenario, we are going to say you want to have your investments (your financial capital) to be producing monthly income of $3,793.85 per month. In the Real Estate Financial Planner™ software we call that your “target monthly income in retirement” and it is your current standard of living taking into account your current level of income, income taxes and savings rate.

The point I was trying to make previously was that the more you save the lower your target monthly income in retirement can be because you’ve been living at a lower standard of living and will continue that same standard of living in retirement. Some other folks in the FIRE community seem to take this logic to the extreme and practice extremely frugality.

Your mother and I have not opted for quite that level of frugality. Whether you choose that or not is up to you. It will help you get to your FIRE date sooner, so you will want to weigh what is most important to you: a lower standard of living on lower spendable income and sooner financial independence and earlier retirement or delayed retirement and a higher standard of living. Mom and I choose a middle group (although I suspect many people looking in would not consider us frugal at all).

Tim on the other hand, might actually have the benefit of self-induced extreme frugality. It will be much easier for him to hit his target monthly income in retirement number and any help he gets from us can have a much bigger impact. I will explain this in a lot more detail when I write about his situation. Back to JC for now.

Inflation

We are moving toward running our first Scenario where you are saving 10% of your income (as we discussed above) and retiring on 90%, but before we do that we need to have a brief discussion about inflation. Later, I will go to freaky town and show how inflation impacts all the plans we’re considering.

For now, I want to point out that things tend to get more expensive over time. Living on $3,793.85 per month in 2018 won’t be the same as living on $3,793.85 per month when you retire. If we look at the Bureau of Labor Statistics historical data on inflation rates since 1958 through the last full year, 2017, the average historical inflation rate has been 3.7% per year and the median has been 2.7% per year. Here is a chart showing the yearly inflation rates.

Annual Inflation Chart 1958-2017
Annual Inflation Chart 1958-2017

For running this first Scenario, I am going to use an inflation rate of 3% per year.

I will assume that you get raises at a rate of 3% per year and that your expenses increase at 3% per year. That also means that the dollar amount that you’re saving increases at 3% per year too.

However, because your personal expenses (which is your standard of living) is increasing at 3% per year because the cost of goods and services are going up, on average, at a rate of 3% per year, your standard of living is staying the same. This is true even though it looks like you’re living on a much higher dollar amount per month.

Another way of looking at this is: if you’re earning the same amount of money each year, you’re actually not keeping even, you’re actually losing ground and lowering your standard of living.

Safe Withdrawal Rate

Imagine for a moment that you’re 40 years old and have a million dollars in the bank. You want to retire and live off that million dollars. How much money can you spend per year so that you never run out of money? This is what we’re talking about when we discuss safe withdrawal rate.

Three professors (Philip L Cooley, Carl M Hubbard and Daniel T Walz) from Trinity University researched this question and wrote a paper about it. In the paper, they concluded “the lower withdrawal rates of 3% and 4% recommended by some analysts appear to be excessively conservative for portfolios with at least 50% stock, unless the investor wishes to leave a substantial portion of the initial retirement portfolio to his/her heirs.” If you start to read about FIRE elsewhere you will see the “4% Rule” referenced. What they are suggesting (usually citing the same Trinity study I linked to above) is that you can safely take 4% of your initial retirement portfolio out per year (adjusting it up with inflation each year) and you’ll be “safe”. I do not agree with this and I would strongly advise you NOT to use 4% as a safe withdrawal rate.

While I have not gotten through all of the content on his blog, Karsten has done some serious research into safe withdrawal rates. From what I’ve read so far, it looks like using 3.25% as a safe withdrawal rate is a much more conservative approach. This is the number I will recommend we use for our modeling of various Scenarios. However, the Real Estate Financial Planner™ software will allow you to enter whatever safe withdrawal rate number you believe to be correct. In the future, should you decide you want to rerun these Scenarios with 3% or 2.75% or, heaven forbid, 5%… you can easily do that by modifying the safe withdrawal rate variable on the Scenarios page.

Since I know you like to do some quick computations, when we were thinking about the 4% rule, you could easily take the amount you needed to earn in retirement and multiply by 25 to quickly discover how much you would need to have invested to generate that amount. So, if you needed $100,000 per year, you would have needed 25 × $100,000 or about $2.5 million at 4% safe withdrawal rate in retirement. With the new, more conservative 3.25%, a really rough rule of thumb might now be 30 times. Using the same $100,000… you’d now need $100,000 × 30 = about $3 million.

Stock Market Rate of Return

For the sake of looking at the impact the percentage of your income that you’re saving will have on your ability to retire early, we are going to use a very simple, but very common investment strategy: investing in an index fund of stocks. For the stock portion of your mother and my investments, we do personally invest in an index fund. So, this strategy isn’t that far fetched.

For determining what rate of return to use for the stock market, I am going to use Simba’s Backtesting Spreadsheet from the Bogleheads website. More specifically, I am going to look at the returns for Vanguard Total Stock Market Index Fund Investor Shares (symbol VTSMX). Your mother and I don’t use this specific index; instead we use one that does the Russell 2000, but that’s not particularly important at this point in our conversation.

The following is a chart showing what the return was for each year going back to 1871 through 2017 for the equivalent of VTSMX.

VTSMX Annual Returns 1871-2017
VTSMX Annual Returns 1871-2017

The following histogram shows how frequently certain ranges of annual returns appear for VTSMX.

VTSMX Frequency of Returns 1871-2017
VTSMX Frequency of Returns 1871-2017

The average return for VTSMX for that period is 10.57%. The median return for that same period was 11.23%. The compounding annual growth rate (CAGR) for that period was 8.97%. For running our Scenario I am going to use the 8.97% CAGR return.

Setting Up The Planner™ To Model Your Situation

I am going to do a very basic model of your situation using the Real Estate Financial Planner™ software. For this very first one, I am going to go into a lot more detail than I will later as we compare it to other Scenarios, so please be patient as I explain to you my assumptions and how I set it up.

Gross Paychecks

First, since you’re earning $70,000 per year, that works out to be $5,833.33 per month in gross from your paychecks. We are assuming that your paycheck is increasing by the inflation rate of 3% per year (but actually calculated monthly). That means that you make $5,833.33 in the first month, but actually make a little more in the second month. It continues to go up a little bit each month such that in month 13, you’re making 3% more than $5,833.33 which is $6,008.33. The following chart shows your gross paychecks for the first 13 months.

If we look at this over 45 years (that’s 540 months), the chart of your gross income looks like this.

Saved 10 - Gross Paychecks - All
Saved 10 – Gross Paychecks – All

If we take that same chart above and we adjust it for inflation, you can see it flat lines your income to be consistently the $5,833.33 per month. Here’s a chart (because I like charts and because I can).

Saved 10 - Inflation Adjusted Gross Paychecks - All
Saved 10 – Inflation Adjusted Gross Paychecks – All

In other words, your inflation-adjusted gross paycheck before takes will remain the same $5,833.33 per month. If ever you feel your income will not keep pace with inflation, you can adjust the income Rule to not automatically adjust your income up with inflation. I personally do not think this is accurate for you.

Paychecks After Taxes

The following chart shows your $5,833.33 per month after we subtract out the 24.96% state and federal income tax we discussed early.

Saved 10 - Paychecks After Taxes - All
Saved 10 – Paychecks After Taxes – All

Personal Expenses

In this particular Scenario we are assuming that your personal living expenses (your standard of living) is $3,794.00 per month. Later on, we can separate out your personal expenses to include the cost of the house you’re living in. For the sake of this simplified Scenario, we are assuming you’re renting and that it is already included in your personal expenses.

Saved 10 - Personal Expenses - All
Saved 10 – Personal Expenses – All

Just like your paychecks, your personal expenses are increasing at a rate of 3% per year.

Savings

If we take your monthly gross paycheck and subtract your income taxes and subtract your personal expenses, what you’re left over with is the amount you’re saving each month. I manipulated your personal expenses for the sake of this Scenario such that you’re saving 10% of your monthly gross paycheck. So, you’re saving 10% of the $5,833.33 per month that you’re earning.

You may have heard of the idea of “pay yourself first”. That’s what I’ve done here. I looked at your paycheck and figured out what 10% of your paycheck would be. We paid income taxes on your paycheck and immediately set aside 10% of the $5,833.33 each month, or $583.33, into your VTSMX investment stock market brokerage account. Then, you lived on whatever was left over. In a few moments, I will walk you through how changing this savings rate will impact your ability to retire early. However, for now… let’s continue looking at how we set up this Scenario.

The following is a chart showing how much each month you’re saving and investing in VTSMX.

Saved 10 - Total Saved From Paychecks - All
Saved 10 – Total Saved From Paychecks – All

If we adjust back for inflation to today’s dollars, you can see we’re really just saving a fixed $583.33 per month.

Saved 10 - Total Saved From Paychecks - All - Inflation Adjusted
Saved 10 – Total Saved From Paychecks – All – Inflation Adjusted

VTSMX Account Balances

As we keep saving $583.33 (and adjusting up with inflation each month) and investing in VTSMX, our account balance for that stock market brokerage account increases. We are assuming that the VTSMX is getting a fixed 8.97% return each and every year. We are not going to discuss the sequence of returns risk here that we get by modeling the return as a static fixed rate of return. I will tell you all about this and run a number of Scenarios that address this for you in the future.

For now, here is a chart showing how compounding your monthly savings into stocks really pays off.

Saved 10 - Account Balances - All
Saved 10 – Account Balances – All

By the time you get to year 45 when you’re 67 years old, you have about $5.4 million dollars saved up in your stock market brokerage account. But, you know that this is in inflated future dollars. If we adjust back to today’s dollars, you really have about $1.4 million dollars. Big difference!

FIRE Date

If you remember, the FIRE date is the date you’ve achieved financial independence and can retire early. For the sake of this Scenario, it is when your VTSMX account balance is high enough that if we take out 3.25% of it in a given year it can support your gross paycheck minus your savings rate. For a 10% savings rate, you need your assets to produce:


Gross Monthly Income - Savings Each Month = Target Monthly Income in Retirement
$5,833.33 - $583.33 = $5,250

But we need to adjust this number up each month for inflation as well. The longer it takes to hit our FIRE date, the more money we actually need.

How long does it take in this example? Turns out it takes 599 months, or a month shy of 50 years to be able to retire. You’d be 72 years old at that point. Of course, you could probably retire a little earlier when you start collecting social security to supplement your shortage at that age. Again, this is assuming you’re only saving 10% of your paycheck. I suspect you’re willing and able to save more. It further assumes you’re investing 100% in VTSMX; I suspect we’ll discuss some additional options as well that might speed it up.

Can you see why people, if they’re saving 10% of their income, end up having to wait until about 65 or so to retire?

Here’s a chart showing what percent toward achieving your goal of having your 3.25% safe withdrawal rate provide you with your target monthly income in retirement number.

Saved 10 - FIRE Goal - All
Saved 10 – FIRE Goal – All

Saving 20%

Not willing to wait 50 years? Me neither. Let’s see what happens if you’re willing to save 20% of your income.

Saving 20% of your income does two things.

First, it lowers the target monthly income in retirement. Remember the formula we just used to calculate this?


Gross Monthly Income - Savings Each Month = Target Monthly Income in Retirement
$5,833.33 - $1,166.77 = $4,666.67

Because you’re saving 20%, your standard of living is lower. You need to be willing and able to live on about $583.33 less per month both during your career and in retirement. That means your personal expenses will need to be less than they were when you were saving 10%. I show this comparison between the two Scenarios in the first 12 months in the chart below.

Saved 10 and 20 - Personal Expenses - 1-12
Saved 10 and 20 – Personal Expenses – 1-12

The second thing that saving 20% does it increases the amount of money you’re investing and putting toward buying back your time. Saving twice as much, as you might expect, doubles your net worth.

Saved 10 and 20 - Net Worth - All
Saved 10 and 20 – Net Worth – All

The combination of both a lower target monthly income number for achieving financial independence and retiring early and saving more money toward achieving that goal moves your ability to FIRE earlier up by about 13 years.

Saved 10 and 20 - Goal - All
Saved 10 and 20 – Goal – All

If you’re willing to save 20% of your gross income, live on $3,210.67 per month (after taxes), invest in the stock market and, if you’re lucky, get almost 9% return per year, you can retire in 36 years and 10 months at the ripe old age of about 59.

Saving 30%

You want to do better? What if you saved 30%? Again, you’d reduce your personal expenses to $2,627.33 per month (after taxes) and you’d be saving about $1,750 per month.

If you did that, you’d be able to retire in 28 years and 10 months at about age 51.

Saved 10-30 - Goals - All
Saved 10-30 – Goals – All

Saving 40%?

Are you able to adopt some serious frugality (and/or get creative with some of your living expenses like we will discuss in a bit) and live on just 60% of your income?

If you did that, you would be living on $2,044.00 in personal expenses (after tax). But, you’d be saving $2,333.33 per month.

Of course, this is an imperfect model. You may be able to save your money pre-tax and so your tax bracket will be lower giving you more money to live on. However, realize that if you decide to do this, you may not be able to easily access those funds without penalties should you decide to retire early.

If you were able to save 40% of your gross income, you’d move your FIRE date up to 22 years and 10 months. You could retire like your mom and I are at about approximately my age now, 45. That’s getting a bit better. I think we’ll be able to improve that as well, but good to know you can do it with an aggressive savings plan and just stocks.

Saved 10-40 - Goals - All
Saved 10-40 – Goals – All

Saving 50% and 60%

If you go to extreme frugality and live on $1,460.67 in personal expenses (after tax) by saving 50% or $877.33 in personal expenses (after tax) by saving 60% of your income, how does that impact your FIRE date?

I will point out that living on $877.33 (even with it being an after-tax amount) is like living on less than minimum wage. I’ve never had to do that, but I suspect it is going to be really challenging to do. I bet that living on $1,460.67 would be a Herculean feat (reference to your childhood intended). I will discuss some of the strategies and benefits of having a much lower standard of living when I write for your brother, Tim. If you could do it, here’s a chart showing what it would look like.

Since this chart is a little harder to read, here’s a table showing the FIRE dates for each.

Saved 10-60 - Goals - Table
Saved 10-60 – Goals – Table

So, with this plan of saving and investing in stocks, the best you’re likely to be able to achieve is a FIRE date about 14 years from now at age 36 for you. And, that would be really hard from a standard of living perspective, in my opinion. Even the 18 year one would be living with extreme frugality and would allow you to retire at age 40. I think we can improve this a bit though and I will discuss some of those ideas next.

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