Are Your 'Retire Early' Numbers Wrong?

If your plan is to retire early, you need to make sure you don't have your numbers all wrong.

Retirement has nothing to do with age. I actually prefer the term work optional, as I think it more adequately describes the financial circumstances that create your ability to retire. When you are able to live off investments indefinitely, you are "work optional". At that time, you have the option to retire.

When you decide to quit earning an income and live off your investment portfolio, you're deciding to use a portion of it each year. So how much can you use without running out of money?

For those retiring at 65, the classic answer is 4% of your portfolio per year.

This means that having $1,000,000 invested will provide you only $40,000 per year to live off of. My suspicion is that this may be a lot less than you thought.

Most of the data behind this is relatively old, and there are plenty of critiques on the methodologies used. The pillar study used for this determination was the Trinity Study, a pivotal study in the world of finance. While it provides tremendous insights, the assumptions ignored fees and assumed a fixed withdrawal that ignored market conditions, namely the "dollar plus inflation" spending model. In addition, it fundamentally is using historical returns to predict future returns (which may be flawed). 

As an aside, your investing fees can easily trash the 4% rule assumption. If you're paying a financial advisor a 1% AUM fee and have invested in funds with an expense ratio of 1% (100 basis points), your likelihood of success is abysmal with a 4% withdrawal rate.

Check out this data from Vanguard looking at an early retiree with fees that total 100 basis points on the far right column (when my above example would actually have total fees of 200 basis points):

I'm Retiring Early!

If your intention is to retire years, or even decades, before the standard mid 60s - your underlying assumptions are quite different. The Trinity Study assumed the traditional 30 year time horizon for retirement, which doesn't hold true for the early retiree. 

So what withdrawal rate is "safe" for the early retiree crowd?

The answer is a lot more complicated than you may think. Vanguard has done research on what it looks like to have a 50 year retirement term (aka retiring at 45 instead of 65). Several other key variables contribute to your success rate, aside from withdrawal rate. The first is retirement spending model. The second is underlying holdings, particularly if you have international exposure in addition to US equities. 

Retirement spending models is a complex topic in and of itself, but I will break down two key options that Vanguard used in its research.

The first is a "dollar plus inflation" model. It's really simple. The first year you withdraw 4%, and then make an inflation adjustment to that number each year following. This creates consistent income, but will increase the likelihood of portfolio depletion in bad markets.

The second is a "dynamic spending model". This model allows you to withdraw more when the market is returning well, and withdraw less when the market is performing poorly. The obvious downside is tremendous variability in income, with a big reduction when the market is down. Better have your cash reserves in place here... 😉

Vanguard's research pointed to the fact that a "dollar plus inflation" model with US & international exposure would require a withdrawal rate of 3.3%. That assumed total fees <20 basis points. If you're investing in expensive funds, the withdrawal rate drops below 3%. That means you would need >$3.3M invested to generate $100K/year to live.

Turns out, if you use a dynamic spending model, have total fees <20 basis points, and have US & international exposure the research suggests you could get away with a 4% withdrawal rate.

Is Science Screwing Us Over?

The rapidly changing landscape of medicine, particularly longevity sciences, may dramatically change the landscape for humanity in the coming decades (and maybe sooner, depending on who you listen to). 

Dr. David Sinclair, a Harvard geneticist and leader in longevity sciences, has demonstrated the ability to speed up and reverse aging in cells in mice, restoring signs of youth. Scientists around the world are racing to determine the underlying etiologies of the incredibly complex process of aging, and find levers to slow or reverse aging in humans.

If the human lifespan can be successfully extended substantially, this will dramatically change wealth models. My own intention is to plan for a lifespan of 120 years, but this is entirely opinion and is based on my exposure to longevity podcasts & books, plus underlying optimism regarding humanity's ability to innovate.

Key questions emerge...

How many of those additional years would be "healthy years"? How many would be income generating? How many years would the standard retirement term be? How would this change retirement benefits?

How does it change your withdrawal rate?

If your withdrawal rate needs to be less than previously assumed to accommodate a longer lifespan, that means you need a larger nest egg. If you're going to need a larger nest egg, does that mean more years working or a higher savings rate?

I don't have the answer to this, but this is something I regularly consider. Don't miss the forest for the trees when crafting your money plan and ensuring you can support the life you want.