In one of my favorite financial books, The Millionaire Next Door, the author, Thomas Stanley, coins the phrase, “big hat, no cattle.” The term describes an individual who, by all appearances, looks like they have wealth but has accumulated well below their means.
In my blog post, Are You Really Cut Out to Be Rich? The Average Net Worth to Make It Into the Top 1%, and How to Get There, I wrote about someone who, at the age of 52, was living large and well beyond his means. He is a good example of a big-hat-no-cattle kind of individual. Had this individual been saving properly, he should have amassed at least 4 to 5 times the amount he’d managed to save. He has a spending problem, and unless he changes some of his living habits, it will make it difficult for this individual to retire.
And that brings me to my next point …How do you know how much you need to retire early, maybe even join the FIRE community, and then how do you go about getting there? (as an FYI, FIRE stands for Financial Independence, Retire Early).
The inspiration for this post came from an email sent by a reader I’ll call George. George asked me the following question: “I’m 45 years old, and I’ve been saving for years. I’m hoping to retire in the next couple of years, but I’m wondering how much is enough?”
In the retirement financial circles, there’s a 4% number (rule) that keeps getting thrown around. The thinking is this:
· Invest in a 50/50 stocks/bonds portfolio
· Earn the equivalent of approximately 8% a year
· With inflation at 2%, you draw down your principal by 4% a year
· Live off your investments for at least 33 years
It’s been a more common practice as of late to question the 4% rule. Some planners suggest that you need anywhere from 3% to 5%, depending on what stage the economic cycle is at when you retire. If you’re putting your dollars to work in a stock market at the peak, you’ll likely need 5%, and if at the trough, then you could draw down closer to 3%.
Either way, if you’re hoping to retire early at the age of 45, or sooner, the last thing you need is to run out of money before you die because of a math mistake.
How much do you need to retire? Or for those hoping to retire young, how much do you need to retire early?
Unless you expect the grim reaper to dig you an early grave, you need to expect that you could live to 100, or maybe even older. That being the case, you have many years of living expenses, many unknowns– including your future health. And from an economic perspective, and even more importantly stock market ups and downs, inflation targets could exceed well beyond the current 2%-a-year range.
Whether you use 3, 4, or 5% as a rule, none of those will truly provide the peace of mind you need when you decide to finally pack your work bags and call it quits.
Plenty of people focus on the top line number, i.e., the amount of dollars you need to have in your account.
Let’s take a different perspective and focus on the bottom line number to start.
When you’re reviewing an income statement, the top line is known as your revenue number, and the net income is known as the bottom line. So let’s focus on the bottom line and look at how much it costs you to live each year.
What Is Your Bottom Line?
What does it cost you to live each year? Let’s use a somewhat generous number of $100,000 after tax for the purposes of this discussion. For starters, it’s an easy number to use from a math perspective. Plus, it’s also large enough that you’re not looking at ramen noodles as a gourmet dinner.
The goal is to build an investment portfolio to provide residual income that will exceed your yearly living expenses without having to spend your initial capital or sell your home to survive. You can spend your income, but your assets should never be touched. With a focus on residual income, it will become easier to retire early.
Keep in mind, $100,000 in today’s dollars isn’t the same as $100,000 next year or the year after once you factor in the inflation monster, but I’ll tackle inflation shortly.
When you can build a portfolio that kicks off enough passive income to exceed your yearly living expenses, then you have enough to retire. And because your passive income exceeds your yearly expenses, you should never need to spend your capital, sell your house, go back to work, or use the 4% rule to survive.
There. Simple enough…But it isn’t quite that simple.
It isn’t that simple because you need to make sure that your portfolio keeps up with inflation. To do that, you need to make sure you include assets that grow with inflation.
Real estate rental income is a perfect example. Not only does the underlying real estate asset grow with inflation, but you can raise the rents year over year, ideally at the inflation rate.
With all of my rental properties, we make sure that we raise the rents every year (as allowed by rent control). Moreover, and even better, when there’s a turnover of the units, the rents are raised to market rates. A unit that rents in 2019 for $1,000 a month will have their rent increase at the rate of inflation. So next year, their rent will be $1,020 a month, and the year after it will be $1,040 a month, and so on.
Dividend-paying stocks are another example of an asset that should grow with inflation, especially if you’re buying stocks that fall into the dividend aristocrat or dividend king classification. Those have a history of raising dividends every year. To fall into the dividend king classification, a stock must have raised its dividend for at least 50 consecutive years.
If you review some of the more popular dividend king stocks, like Procter & Gamble (NYSE:PG), for example, they have a current yield of 3.9% and a 10-year compound annual growth rate (CAGR) of 7.7%. Or 3M is another example, with a 2.7% dividend yield and a 9.4% CAGR. Both of these stocks have a history of paying dividends that keep up with inflation. There are many others, and to make your life easier, you can purchase an ETF, like the iShares Select Dividend ETF (symbol DVY) as an example, or the iShares US Dividend Growers ETF (symbol CUD).
In order to build your inflation-proof retire-early portfolio, you can’t have all of your eggs in one basket, so you need a mix of assets, ideally somewhat uncorrelated, which pay dividends that keep up with inflation.
If you own a five-plex rental unit that provides an income of $40,000 a year, and a million-dollar dividend-paying stock portfolio that pays a 5% dividend (total of $50,000 a year in dividends), you now have $90,000 a year in before-tax income. You can purchase an inflation-adjusted fixed annuity royalty income, and maybe even a pension income (either from work or from the government), in order to hit your bottom line number.
You will notice that throughout this blog post, I never discussed the top-line number. It would have been easy to suggest that you have a $2,500,000 portfolio at a 4% yearly drawdown.
Instead, I suggest you first understand your yearly spending requirements, and then focus on your bottom line and seek to build a portfolio that provides a steady stream of inflation-protected passive income that hits or exceeds your yearly spend. Easier said than done of course, but that’s the real gold standard in planning for your early retirement.
As an aside, according to this CNBC article, $1.7 million is the magic retirement number.
Happy saving (and spending) enjoy the journey, and good luck on the path to retire early.
Here’s one of the first articles I wrote: My Journey Post Business Sale as I Sail Into a New Harbour.
Are you a younger entrepreneur? Here’s another interesting article I wrote:
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