When it comes to personal finance, some things matter more than others. The secret to wealth is no secret, and getting rich slowly works best. The path to wealth is to make a lot of money, save a lot of it, and to make your money work as hard as you do. Consider the decisions made by two physician partners and the eventual effects on their wealth level. Let's start them out at age 35, perfectly equal in the same specialty, practice, and net worth. They both just finished paying off their student loans. They are both currently grossing $300K per year.
Doctor Rich
Doctor Rich decides they are going to pick up some extra shifts (or call), increasing their income by 20% to $360K. They also decide they are going to save 25% of their income each year. They read a few good books and learn about investing and decide to run their portfolio themself, using a reasonable collection of index funds and earning a 5% real (after-inflation) return on that portfolio.
Doctor Average
Doctor Average decides they would rather have the time off than pick up the extra shifts (or call), so they maintain their income of $300K a year. They decide they are going to save 15% of their income. They mistakenly hire a mutual fund salesman and an insurance agent as their financial advisors, and don't realize their mistake for 10 years, so their portfolio earns just 1% real for the first ten years. After that, they hire a good fee-only manager who charged 1% on a portfolio similar to that of Doctor Rich, so they then earned 4% real on it.
If they both work to age 65, how much more will Doctor Rich have? If Doctor Rich decides they want to retire early, how much sooner can they retire on the same retirement income as Doctor Average?
The Future Value Function
The best way to answer these questions is to use a good financial calculator or spreadsheet with the Future Value (FV) function. The inputs to this function include:
- Annual Interest Rate Earned
- Number of years
- Present Value
- Annual Contribution
- Whether the money is contributed at the end of the period vs. the beginning
The function looks like this in Microsoft Excel:
Future Value = FV(interest rate,number of years,annual contribution,present value,1)
The annual contribution and present value numbers should be negative. The timing of the contribution is 1 if done at the beginning of the period, 0 if done at the end. so for Doctor Rich, it looks like this:
FV(5%,30,-90000,0,1) = $6.28M
If you apply the 4% rule, that means they will have $251,000 in today's dollars to spend each year in retirement.
for Doctor Average, it looks like this:
FV(4%,20,-45000,-FV(1%,10,-45000,0,1),1) = $2.44M
Using the 4% rule, that's an income of $97,000 per year in today's dollars. Is that enough to retire? Almost surely. Is it very different from Doctor Rich's stash? Less than 40%.
Early Retirement
What if Doctor Rich only needed $97,000 in income (same as Doctor Average) to retire? How much sooner could they retire than Doctor Average?
FV(5%,17,-90000,0,1) = $2.44M
It turns out they could retire after just 17 years, at age 52. They get 13 more years of financial freedom than Doctor Average. Did Doctor Rich have to impoverish themself to do this? Not really. They probably paid something like 25% of their income in taxes, and put 25% of it toward retirement. That left them $180,000 to live on, or $15,000 a month. If Doctor Average paid 20% of their income in taxes, and put 15% of their $300K income toward retirement, they only had $195,000 a year to live on, or $16,250 a month, a similar spendable income. They did get an extra 3 days off each month and didn't have to read any investment books, but neither of those seems like a huge sacrifice to retire 13 years earlier or 2.5 times richer.
There is no right answer to how much extra you should work, what percentage of your income you should save, or whether or not you should use a good advisor (although no one should use a salesman as an advisor). But there are very real financial consequences to your decisions. The Future Value function helps you understand what they are. Be sure to use after-inflation numbers when running your own scenarios.
What do you think? Have you used the Future Value function or a similar financial calculator to run your own numbers? What did you learn? What surprised you?