Monday, September 04, 2006

How Much is Needed to Be Wealthy - THE NUMBER

My personal answer is when I have enough to be able quit my job and live on the money generated by my savings and investments. I can always to choose to continue working, but I don't have to.

In the past, I wasn't sure what THE NUMBER was. At one point, I thought it was one million dollars. Then that didn't seem like enough. However, I just read an article that defines THE NUMBER relative to our current income and expected life expectancy. "Personal Financial Ratios: An Elegant Road Map to Financial Health and Retirement" by Charles J. Farrell, J.D., L.L.M states that people can retire comfortably at 65 if they have saved 12 times their income, have been routinely savings 12% of their income since 30, and have zero debt. If they withdraw their savings at 5% per year they will have 60% of their pre-retirement income. Social Security will provide another 20%, giving them 80% of their pre-retirement income. This will work if they have been saving 12% and therefore, living on 88% of the income.

Of course, he makes the normal real rate of return assumptions (5%) and that Social Security will still be able to pay. Also, I believe that he assumes this strategy has a high probability of lasting the lifetime of the person. (I will do the calculation for a later post.)

This approach resonates with me. I have put in the numbers for my own situation and come up with what appears to be an accurate estimate. Also this approach allows me to adjust based on different assumptions. If I don't expect Social Security to exist, I should retire with 16 times my final salary to achieve 80% of my income. Or if I want 100% of my final salary, I should have saved 20 times my final salary. Now I can know MY NUMBER. And so can everyone else.

One benefit of this is we can all discuss our goals without sharing THE NUMBER. We can use the ratios. I show my targets for Savings Ratio, Debt Ratio, and Income Ratio in the sidebar. Since I don't expect to get Social Security and would like 80% of my income, my target Savings Ratio is 16 and my target Income Ratio is 0.80. Target Debt Ratio is always zero. If I hit these targets earlier than 65, I can retire.

October 7, 2006 Update - Based on an analysis done by my financial advisor, I have increased my target saving ratio to 20. For more details, see Updating My Wealth Ratios - Q3 2006.

This is not financial or retirement advice. Please consult a professional advisor.

Copyright © 2006 Achievement Catalyst, LLC

8 comments:

The Travelin' Man said...

I was with you right up until the last line - "If I hit these targets earlier than 65, I can retire." I think the multiplier assumptions are based on the 65 year retirement age for a reason - average life expectancy from the time of retirement. If you retire earlier than 65, and start drawing out your retirement funds, you will likely run out of money before you die.

On the other hand, you can't take it with you! :)

Super Saver said...

Travelin' Man,

Thanks for your comment and your inquiry on the sufficiency of funds when retiring before 65. It's a very good point.

In this simplified example, I can retire earlier because of the assumption of a 5% real rate of return over inflation. As it turns out, the withdrawal rate to achieve 80% of final income (at Saving Ratio of 16) is also 5%. So theoretically, the retirement funds can last forever with these assumptions:-)

However, the reality is yearly returns will sometimes be lower. My financial advisor ran a Monte Carlo simulation (which takes into account variations in yearly returns) for retiring at 50 and showed there was a 35% chance running out of money with a savings ratio of 16:-( He used a conservative 2.5% real rate of return for this analysis. His analysis convinced me it would be safer to target for a Saving Ratio of 20.

I have added a link to the October post with the update to my Saving Ratio.

Anonymous said...

I realize it's been a year since this post (and you have also retired since then) but I have to mention that a savings of 16 times your annual income won't cover cost-of-living increases. So if you give yourself a raise each year just to keep up with inflation you'll run out of money much sooner. (Even a Ratio of 20 times your income might not be enough given your age)

Super Saver said...

Anonymous,

Thanks for your comment and bringing up a good point.

While 16 to 20 times gross salary is a good start, one needs to do a more detailed analysis as the time gets closer. You are correct that there is a chance that I will run out of money. However, with assumptions of 7% annual returns and 3% inflation, the Monte Carlo analysis shows a 8-14% chance of that happening before 95ish. The failures happen mainly because of poor investment returns in the first few years.

To protect against this risk, we are taking two steps. First, we will target to spend less in the first year or two than our long term spend rate. Second, I will have a couple part time jobs as a backup, should we need them. Both of these actions should provide an additional buffer should we need it.

Worst case, of course, is that I return to work full time in the next couple years, while I still am marketable.

Adrian J said...

Congratulations on your retirement. It is now almost 2 years later ... market has crashed ... how has that changed your plans, if at all?

Two books that you may want to read on 'safe retirement':

- Worry Free Investing by Zvi Bodie, and

- Grangaard Strategy: Invest Right During Retirement.

PS if your advisor says that you cannot tax-advantage TIPS, ask him about inflation-protected-MUNI's instead (these are a 'special' form of Municipal bonds that automatically protect against inflation).

Super Saver said...

@ Adrian,

Thanks for the book recommendations. At this point, we are still proceeding with our original early retirement plan. I am closely watching our savings and investment situation to determine if any changes are needed.

enoughwealth@yahoo.com said...

These seem like sensible numbers for a sustainable retirement with a retirement income roughly at pre-retirement salary level. But, why go straight from full-time employment to an unemployed retirement? Especially if one 'retires' at a young age, doing some part-time or casual work would have a massive impact on how long your savings last, and what sort of estate you could leave your kids and descendents (or to charity).

Thomas Watson said...

Rich. What is rich? There is no formal quantitative measure--but I personally view it as upper 1% net worth.