I will just focus on numbers in this post. No emotions, no other life conditions, just numbers. When I started writing about “having enough”, I realized that I can also cover becoming a millionaire topic in the same article since many people’s yearly spending target will require an accumulated net worth over a million dollars to call quits (if they are planning to spend at least $40,000 a year when they retire). Don’t get discouraged right away, you will feel quite the opposite when you finish reading this post, I promise. Just keep reading.
To determine when you can pull the plug from Corporate America, first we need to know when we get there. For this, we need to know how much is enough, in other words “your number” to hit. As I mentioned in earlier, the ultimate number that we care about is net worth (and of course it should not be sitting in a checking account, it should be invested). Let’s set the target.
You must have heard the 4% rule by now. If not, here’s a quick recap. A well-known research (Trinity Study) has shown that if you withdraw 4% of your investment portfolio the first year that you retire, and increase it by the inflation rate in the following years, you don’t run out of money, even if you retire at the worst possible time.
We will take this as our goal. You will hear objections about how this study is outdated, why it doesn’t reflect today’s conditions, why the future will be very different from the past etc. Don’t worry about any of these for a number of reasons:
1) During the time frame that this research covers, all of the following happened: Two world wars, Great Depression, hyper-inflationary period in 70s, cold war, dot-com crash, 2009 financial crisis and numerous recessions. 4% rule survived them all.
2) 4% withdrawal rate assumes you will not earn a dollar again for the rest of your life other than what your investment portfolio provides you. Chances of this happening is next to 0. I don’t know a single person who retired early and never made another dollar. None. Even if you try not to make another dollar, chances are you will.
3) 4% is calculated based on surviving the worst possible time to retire which by definition is a very small likelihood for you and I. Even if you managed to not make another dime after you “retire” and withdraw based on the 4% rule, chances are you will have a big bank account when you pass over to the other side.
4) 4% assumes you will never decrease your spending and you are completely inflexible. In reality, if we see a 50% market decline -even though we know that we will be ok- we would all probably adjust our lifestyle temporarily and decrease our spending a bit.
5) Still not convinced? Still want to go hyper analytical and find the bottom of the rabbit hole, check out this post from ERN (again you don’t need to, I researched it all for you): https://earlyretirementnow.com/2016/12/07/the-ultimate-guide-to-safe-withdrawal-rates-part-1-intro/
Ok, I hope that was adequate. So how do we translate 4% to our target net worth number? It’s pretty simple, all we need is your targeted annual spending amount and multiple it by 25. For example, if you want to live a lifestyle that requires you to spend $50,000 a year, then you need to build a net worth of $1,250,000 (4% of $1.25m is $50k).
To be able to set your spending target, first you need to know how much you are spending today. Only then, you can make any adjustments to come up with your future spending target. I use Mint to track all of my expenses and see my monthly spending range.
Caution: Do not just take last month’s spending and multiply by 12 since month to month spending can vary significantly, mostly driven by large one-time expenses (e.g. vacations, big purchases, speeding tickets, Cristal champagne bottles at overpriced clubs, other regrettable spending when under influence). I typically look at my last 6 to 12-month expenses to have an idea about my average spending level.
Now that you know how much you have been spending, think about your desired future spending level. Will it be different from today? Maybe you will choose to be more frugal until you hit your number, but splurge a bit when you reach financial independence. Set your spending target based on your desired future lifestyle.
Once you set your annual spending target, multiple it by 25 and voila! Now you have a net worth target to track against. This is very empowering as this will enable you to progress toward a well-set target rather than moving in the dark randomly.
Does your number sound too high and unreachable? Maybe it does, but chances are it is not unreachable. Remember that hitting your target number is not going to come from just saving money! If it was the case, then very very few people would ever become millionaires. For example, if you saved $1,000 a month, it would take 83 years to accumulate $1 million. Not fun.
Today there are almost 20 million millionaires in the US most of which are first generation self-made millionaires. So, how is that possible?
Let me remind you the power of compounding. Compounding comes from the power of your money that’s working for you. Assuming you start with $0 net worth and using an average return of 8%,
- If you saved and invested $1,000 a month, you’d become a millionaire in 27 years,
- If you saved and invested $2,000 a month, you’d become a millionaire in 20 years,
- If you saved and invested $3,000 a month, you’d become a millionaire in 16 years,
- If you are high roller in Silicon Valley making over $200,000 while saving and investing $6,000 a month, you’d become a millionaire in just 10 years.
Note that in the first scenario above (saving $1,000/month), in Year 27 (the final year before reaching $1M net worth), you will contribute $12,000 to your net worth from savings through your day job, while your previous investments (aka money working for you) contribute $77,000 through investment returns in a single year! That’s the key to building wealth, making your money work hard for you.
Here’s another cool fact that most people don’t realize. Once you’ve made your first million, guess how long it takes for you make your second million? Assuming the same market return, only 7 more years. Your third million? Less than 5 more years. You got the idea. More you grow your net worth, the faster it grows.
There you go. Now you know when you can go into the office of your boss and give them a hug, and call it quits without worrying about ever running out of money.
Ok future millionaire, if you are ready to kick off the journey, here are all of the tactical steps that you need to take: 7 Super Tactical Steps for Reaching Financial Independence.
Take the first step and the rest will come much easier!