You have a secret weapon that you may not even know about. It can be extraordinarily powerful although is the classic “simple, but not easy” to use. What is the secret weapon? Spending less money. Let me explain.
Your Secret Weapon and Financial Independence
Financial independence is the new retirement. Retirement just isn't hip enough any more. Now the goal is to be financially independent. Financial independence is a number, not a date. There is some debate about how to calculate the number, but the most widely used formula is this:
Financial Independence = (Annual spending – guaranteed annual income) x 25
There's not a lot you can do about your guaranteed annual income. This is usually a pension or Social Security. You can buy a pension (i.e. a Single Premium Immediate Annuity) but that does reduce your nest egg. You can also call real estate income “guaranteed,” although of course it isn't and tends to become non-guaranteed at the worst possible times.
A not-so-secret weapon, despite the camouflage
There also isn't a lot you can do about the “25” portion of the equation. Some people argue it should be 30 or even 33. Lunatics (just kidding, I mean hyper-conservative pessimists) argue it should be 40. Optimists might argue it could be as low as 20, but 25 is in the general ballpark.
But what can you do a lot about? You can do an awful lot about how much you spend. That's your secret weapon. We're technically not financially independent yet unless you count the value of our most illiquid asset (this website.) That's because we spend a lot more than the equivalent of 1/25th of our assets each year. However, if we chose to implement our “secret weapon,” we could be financially independent today. Let me explain.
As I write this (months ago it should be noted), our retirement nest egg (i.e. that portion of our net worth dedicated to retirement) is about $1.5 Million. Our net worth is about twice that when you consider the value of our house, our business, and resources dedicated toward other goals, like an emergency fund, paying off our mortgage, and college. [Update just prior to publication: Our net worth is highly dependent on the value of this business, which was revalued dramatically upward between the time this post was written and the time it ran.]
That $1.5M nest egg could support an income of something like $60K a year. So if we only spent $60K a year, we would be financially independent right now. Could we get by on only $60K a year? You betcha. We've spent a significant portion of our married life (all but the last 7 years) spending less than that. Would I rather work at this point than live on $60K a year? Absolutely. In fact, I'd probably work even if we had a nest egg 5 times that size because I'm trying to only do work I like. But the option to cut back and spend less and be financially independent right now is a secret weapon we could employ at any time.
Your Secret Weapon and Sequence of Returns Risk
Let's talk about another time when the secret weapon could be profitably employed. I was having a discussion on a forum recently with one of those fanatics advocating for a 40X nest egg. You know the arguments- expected future returns are low, longevity is going up, I'm retiring early, the world is going to hell in a hand basket etc. The problem is that people don't apply the “real world” factor. In the real world, people don't lock themselves into some bizarre withdrawal plan on the eve of their retirement. They make adjustments as they go. The type of person who can save up 25X of their expenses to retire is precisely the person who can actually adjust what he spends in retirement to make sure he doesn't run out of money.
Sequence of returns risk is that risk that you run out of money in retirement because despite having adequate average returns, you get the bad returns early on and the good returns late. So how do you employ the secret weapon? If bad returns show up early in retirement, you start spending less money. Crazy, right? But if you have the ability to do that, you can probably enjoy a much higher withdrawal rate than someone without that secret weapon.
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What does that look like? Well, let's say you like to send your 20 grandkids $200 each for their birthdays and Christmas. If you employ the secret weapon, you only send them $50 a piece. Maybe you would like to go on three cruises a year. With the secret weapon, you go on one. Maybe you want to get a new car every 8 years. If those lousy early returns show up, maybe you wait 10-12. Cheaper booze. Less eating out. Watch the old TV for another year instead of upgrading. Voila! You got your portfolio through the bad return years with minimal damage and can now get on with the rest of your retirement.
Spending less is a secret weapon that can have a dramatic effect both on getting to financial independence and dealing with sequence of returns risk.
What do you think? If you employed your secret weapon could you be financially independent today? Could you cut back on your spending in retirement if you had to? Why or why not? Comment below!
I had no idea where you were going here until the “punch line”. 🙂
Spending less as a secret weapon is a great point! Perhaps the only caveat to consider is NOT to pull the trigger on retirement when you are right at the border. For example, if your living expenses are X and you have X times 25, you really aren’t ready because you don’t have margin. If your living + lifestyle expenses are Y and you have Y times 25, then you’ve got wiggle room and are much more likely to be able to manage through downturns.
Also, the sequence of returns point is an excellent one. A lot of people don’t take this into consideration. It’s one of the reasons I like (love/hate) Monte Carlo simulators. Returns are never consistent straight-line results so that variability (volatility) needs to be factored into the planning for sure.
Bear in mind that the 4% rule includes downturns. It isn’t 4% of what you now have, but 4% of what you had when you retired, adjusted for inflation. It worked through the Great Depression, WWII, Stagflation etc. The margin is already built in. If you’re going to get some margin too, then perhaps it’s 5 or 6%!
For me, I feel my ability to cut back on spending would be highly dependent on how early I decided to retire. A very early retirement (40s) I think would require a little extra cushion given a long time horizon ahead as well as the many “one time” purchases (i.e. New car, roof, kitchen remodel) that throw off any yearly budget.
However, I agree that feeling that one needs greater than 25x expenses to retire at age 60 borders on lunatic. If you do run out of money, it would likely be in your late 80s or 90s. How much money do you need then anyway? I know that’s personal but assuming I have no debt, I imagine that social security would be all I need at that age since I doubt many people “need” to lead a luxurious lifestyle at that age.
In short, to me, there is a big difference between sacrificing lifestyle in your 40s, 50s, 60s versus 80s
I agree completely. A retirement likely to last 40 years or longer probably does need around 30x annual expenses to have what most consider a good margin of security. But considering that most of us aren’t even going to survive to age 90, a 30 year retirement is probably on the long side for typical retirees. According to the Social Security Administration, there’s only an 18% chance of at least one of two opposite-sex spouses aged 65 surviving to age 95.
Further, retirees’ inflation-adjusted spending tends to drop 1-2% each year of retirement, even through their 80s when increased medical expenses slow down this trend but still don’t reverse it. Michael Kitces estimates that if this was accounted for, the “4% rule” would turn into the “4.4-4.8%” rule.
This post is brilliant, I think it clarified for me and my H where we stand on withdrawal rate. Great point: amassing x25 one’s annual spending is indicative of controlled/frugal living when needed. I think a good point of reference if you’re on the fence is how you responded to past financial pinches- we went through an unexpected job transfer last year (2 months to prepare for 2 months without income and many move related costs) the exact week we paid off the last student loan, which meant little liquid savings- so we just slashed expenses and made it through. LOTS of short term discomfort, but our lifestyle a year later feels great, and it was all bc we were flexible enough in our hardtimes lifestyle (humility+stubbornness?) to not detour from our long term financial plan.
“The type of person who can save up 25X of their expenses to retire is precisely the person who can actually adjust what he spends in retirement to make sure he doesn’t run out of money.”
One could argue that a conscientious individual who has saved a part of each paycheck for 20-30 years would have MORE difficulty adjusting spending on the fly in retirement. A person like this would be great at sticking to a budget; it’s changing the plan on the fly that could be challenging.
Agree that the age at retirement (and life expectancy) also need to be considered when deciding nest egg number. Good food for thought as usual!
Dr. C
This is an interesting thought to consider, but I respectfully disagree. It wasn’t robotically applying a budget that helped us pay off $100k in the same 12 months we changed jobs with a low range doc/government attorney income. It was a dogged commitment to spend what we had coming in, regardless of how low that was temporarily. It’s a value issue too. 20-30 years means fielding lots of change on the fly.
You are 100% right though that the big concern is still how many years one is required to face all that adjusting. I wouldn’t want to live frugaly for 50+ years.
Point taken, but I don’t think anyone really knows how they would respond to a sharp contraction of their annual budget in retirement—until it happens. I suspect a big part of why many oversave (i.e. 40x expenses) is because they can know with high certainty that they will never have to cut their budget.
This is exactly why I did (and recommend) taking a trial run at FI life, before you start that transition. An early look at retirement, to start asking these questions.
It’s useful even when far from FI or retirement. I’m finishing a two-year break, and know how far I can cut. I also now know how far my wife is unwilling to cut — so back into the job-market and side-hustles I go! 😉
At what point would sequence of return risk cease to be a problem? I would think if a portfolio went through a significant downturn in the first 1-2 years returning to work would be a secret weapon as well. As a physician, the ability to return to practice rapidly decreases after a couple of years though.
Having retired in our 50s I keep that secret weapon- returning to work- in my back pocket, at least for a few years. My H however has declined to do that. The math supports his decision.
Ahhh, unfortunately the secret weapon still puts FIRE out of reach for us. We’ve got a ways to go since we’re still paying down debt, but one day we plan to retire early. 🙂
Amazing how much being debt-free speeds up that process.
This is very intuitive and should be easy to accomplish for the high earner and retired physician with a multimillion dollar portfolio.
Yes, if you are counting on your $5M portfolio to spin off $200k per year, you can visit Yellowstone instead of Mount Blanc and drink Chiani instead of Barolo. No big deal.
However, if you have a smaller nest egg (say, $1M, which is a lot of money!) and are counting on $40k per year to pay for basic living expenses in an early retirement, your margin for error is much slimmer. If you need a new roof, you might not be able to eat for a year.
Absolutely. It’s a secret weapon that high income professionals have, not everyone.
We tried and deploy our secret weapon last month to have a low spending month. If you remove the cost of auto and umbrella policies (paid annually in May) then we dropped our spending by approximately 3K. Not bad considering we still bought new furniture over the course of May.
As far as returns go, Mr Money Mustache retired at the beginning of the financial crisis. As returns fell, his spending habits change. So as you say, the person you can retire early typically can adjust to their earnings situation.
The more I evaluate my future the more I think I will be working part time until 60 years old (another 23 years from now) when my pension kicks in (and free insurance, whatever insurance may look like in 23 years). Working down to 60% seems like a pretty cush gig.
Why does the rule of 25 seem to assume that you get to spend the entire 4%? It seems like a big chunk of the 4% will go to taxes in retirement, unless you have massive Roth accounts.
Taxes are an expense, but yes, you do need to adjust for them unless all your money is in muni bonds and Roth IRAs. But given the dramatically lower effective tax rate more docs will see in retirement, it can almost be ignored.
The secret weapon is especially available to high-income professionals like physicians, who will likely be able to create a significant amount of wealth and have a lot of discretionary income during retirement. If the stock market were to fall early inretirement, they can easily reduce their discretionary spending. For lower-income individuals, whose spending is mostly non-discretionary, especially if they have a mortgage, the ability to deploy the secret weapon during lean times is more challenging.
You don’t think skipping my heli skiing trip would be challenging?! Have you SEEN the lift lines at a resort on a powder day?!
Put another way, for every $1000 you can reduce your consumption per month (i.e. secret weapon), you can reduce your FI number by $300,000 ($1K x 12 mo. x 25). So . . . as you are contemplating what your “number” is, a good question becomes, would you rather delay FI while you build up that additional $300,000 or reduce your consumption? Lot’s of variables in this question, but worth thinking about. Likely it depends on how long to save/build the $300,000. In my personal calculus, if it would take 5+ years, then it’s worth looking to cut consumption. Currently, I can accumulate that in around 2 years, so it’s worth it to me to keep building the nest egg in order to add that additional $1K/mo to the pile. (Incidentally, I recall Jim saying that if WCI didn’t start paying $1000/mo at the end of 2 years after starting, he would cut bait.) How many years would you work in order to produce $1K/mo (additional) passive income?
I love learning numbers- thank you for teaching this one.
I think you might even call the psychology the “anti-wealth effect”. If the markets drops on you early in retirement then you will naturally curb your discretionary expenses the opposite of the wealth effect of a raging bull market. The actual number is a moving target. The 25X is just a ballpark figure to shoot for. No one knows what inflation, PE ratios, Case-Schiller or any other number will do. I think you will know when you approach the number you need if you are reading about this topic and plan for it.
This reminds me of “living like a resident” to get rid of loans, except you can still live way better than a resident in retirement (hopefully).
Is the 4% withdrawal rate a rate that should replenish your next egg each year and it won’t go down or is that a rate where you can theoretically take 4%/ yr and it won’t be depleated by the time you die?
The second. More details here:
https://www.whitecoatinvestor.com/the-4-rule-safe-withdrawal-rates/
Thanks for that!
So if you’re planning to live more than 30 years after retirement you need significantly more than 25x annual spending or a smaller withdrawal rate?
What withdrawal rate do you recommend if you want to leave a nice nest egg to your kids?
There are far too many variables to give a concrete answer. Your risk tolerance plays a role. I think 30x to 33x (a 3% to 3.33% withdrawal rate) should be good to alleviate any fears.
But even at a 4% withdrawal rate (and adjusting for inflation), the average outcome based on simulations is to have about 2.7 times as much money as you started with after 30 years. Sequence of returns will play a larger factor in your ability to leave a legacy than the starting amount.
In general after 30 years using a 4% retirement, on average you have 2.7X what you retired with. That can generally be used for that time period beyond 30 years or be a nice nest egg for the kids. In the rare event you spend most of it down in 30 years, well, too bad for them. If you want a guaranteed amount left at death, buy a guaranteed universal life insurance policy and put it in an ILIT.
Generally speaking, for a retirement planned to be over 30 years, 30x annual spending is considered to be quite safe by most.
Even with a 4% withdrawal rate, retirees are very likely to leave behind several times what they started with at the end of the 30 year retirement. There have only been a very few instances in history where a 4% withdrawal rate would have largely depleted the retiree’s portfolio over 30 years.
We definitely could spend less to be FI earlier. I even wrote a post of just such a possibility. But… my life is fairly optimized based on my current spending today. I could reduce spending but it would start impacting my personal happiness if it were even moderate in size. As such I plan so this is only a last resort.
Move to a state with zero income taxes
If you have 5 million you have no need to worry about taxes; that IRA money was never taxed
Most will spend 60-70% of their pre retirement income; much less if you move to FLA.
That number for docs is likely to be in the 25-50% range as I’ve written here:
https://www.whitecoatinvestor.com/percentage-of-current-income-needed-in-retirement/
Yep, no need/plan for us to hit even close to 50% of gross income for retirement spending. Must differ with Ken’s comment about “no need to worry about taxes” though. During our early years in retirement, when we are doing aggressive Roth conversions, federal income taxes will be a substantial portion of our spending–albeit at a much smaller rate than that at which we put it in.
This “secret weapon” is the key for our planning to live on a fixed percentage withdrawal. Year one (8/17-7/18), we will spend about twice our current post-tax (and post-kids) amount. If financial armageddon occurs sometime in the first decade (the key years for SofR risk), we can slash and still live quite well.
Not sure the tax bill on the Roth conversions “counts” toward Ken’s statement. You’re really just moving around retirement money and giving the government part of their portion of the retirement accounts.
The psychological challenges that you encounter when you get to FI are not trivial. My own experience is that they are “under-estimated” by many. Going from being a big saver, to being a net spender is quite a shift.
It is so hard, I have found it better to start with small steps – work part-time, let one spouse continue to work for a couple of years etc. helps you adjust psychologically as well as financially.
There are also real concerns – someone above said you can go back to work……..whoa on that notion. Unless you have a trade or skill that is not time sensitive, you will find you become less attractive to the market place. Your contacts become less relevant over time, you yourself will not seem as sharp should you re-join your profession. You will not go back to earning what you used to. Medicine may be different, but for many who have a more typical “business” career, leaving is something you do only once. You will stop and wonder if a couple of extra years past FI is not more prudent.
Shifting to FI is harder than many imagine.
KJF
I agree the psychology of switching from super-saver to spender is going to be tough for me.
This is a great point that many people overlook because they lock themselves into assumptions. Withdrawal rates of 4%. Inflation rate of 3%. Spending exactly $50,000 per year etc. These assumptions don’t matter as much when you adjust your spending.
Heck, there are tons of retirees currently who live just on Social Security. They may not live luxurious lives and they may complain a whole lot, but they’re still doing fine. Just save as much as you can and remain flexible in the future and you should be just fine.
The trick is to over shoot your goal so you can be more conservative and sleep well
Getting 3-4% relatively safely nowadays is not difficult with bonds of various entities and maturities
always the possibility that some day our wonderful govt will change the rules midstream, and require rmds for roths and kill the inherited ira with distributions paid out over 5yrs
The secret weapon of relative frugality works on multiple fronts. By learning to live on less, you:
1. Have more money to save / invest, building your nest egg more quickly.
2. Have a smaller nest egg target.
If you’re aiming for financial independence, spending less can get you there more quickly than earning more. Increasing income does give you more to invest but your target remains the same. Of course, doing both (spending less and earning more) is ideal. Improve both offense and defense.
Cheers!
-PoF
Sequence of return risk is not that bad if your financial behavior is under control
I retired at the end of 2005 with a 1M all equities portfolio
Two years later was 2008……my portfolio went to .6M. I didn’t sell anything. I believe in our free enterprise economic system combined with a democracy
Today my portfolio is 1.5M, 3 times what is was in 2008 and 50% more than it was when I retired even though I have lived on it for 11 years and taken 10 RMD out of it
Volatility is not risk. Risk is running out of money……..Gordon
I would consider our secret weapon to be pretty good (we are planning to target 60K/year in retirement spending). However, it is not good enough to call us financially independent at this time. In order to retire today, we would need to be able to live on around $16,000 per year, which incidentally is the federal poverty limit for a family of two. Unless we can find a way to live in a tent and eat beans and rice for every meal, we still have some work to do.
This topic was described a long time ago by MMM in the
The 4 % rule, the easy answer to how much you need to retire , the best explanation I have ever read , thanks.
I came here for the get rich quick secret weapon that I hadn’t heard of. Turns out you just want me to be financially responsible. Dang it.
I actually think 20x is perfectly safe. Like you said you can always make adjustments to spending, you can always side hustle a little, have a rental, or maybe you even get social security at some point. Even if you made zero adjustments and never earned a penny in retirement you still have 66% chance roughly.