Believe it or not, it’s pretty simple.
No complicated math is required and you don’t have to be a financial expert.
However, the bad news is almost nobody will do it.
According to Employee Benefit Research Institute, more than half of U.S. workers have less than $25,000 in accumulated savings and less than 46% have even bothered to figure out how much money they need to retire.
This not the way to retire in 10 years, but it is a prescription for serious financial problems later in life.
You can do better when you understand the following simple principles…
Getting The Assumptions Right
In order to retire with long-term financial security your goal should be to accumulate enough assets that your investment income is greater than your living expenses.
There are three approaches to building assets. The first and most common is to save your earned income in paper assets (stocks, bonds, mutual funds). This is what every stock broker and 401(k) planner is trying to help you do. The other two less common approaches are income-producing real estate and owning your own business.
This article focuses on the traditional path – saving your way to retirement with paper assets – because it is the first choice for the vast majority of wage-earning employees. It is also the simplest and most certain path to attaining the goal.
The unique thing about this path is how it’s governed by precise mathematics. There is no vagary about how long it will take you to achieve your financial goal and whether or not you will actually reach the goal. Specific actions produce specific results. It is science.
Let’s look at how the science works…
Calculating How Much You Need To Save For Retirement
Let’s assume you bring home $60,000 in after-tax income per year. That works out to $5,000 per month.
(If you don’t like that income number choose whatever works for you because the exact amount of income makes no difference. I just picked this number to keep the math simple. The percentage of income saved is all that matters.
Using a retirement calculator, we will determine how long it takes to achieve financial independence by applying industry standard assumptions like 3% of investment assets for retirement spending and 8% for compound annual growth.
- If you save 70% of your income ($3,500 per month) you would accumulate a $644,000 nest egg in 10 years. This would be sufficient to produce $19,320 in annual income resulting in financial independence because it would be greater than the $18,000 you’re currently living on.
- If you save just 10% more (80% or $4,000) per month you would accumulate $451,000 in just 7 years providing $13,530 in retirement income at 3%. This would exceed the $12,000 you were living on making you financially independent in a remarkably short period of time (7 years).
By now, your mind is probably screaming, “This article is nonsense! Nobody lives on $12K-18K per year or saves 70-80% of earned income.”
Well, actually, yes, they do.
Search the internet for blogging communities focused on frugality and extreme early retirement and you will find whole communities of people walking-the-talk right now. I’m not claiming it’s easy, but it’s not that hard either. People do it every day.
The truth is it’s a choice – a statement of values. Extreme frugalists would sooner live from a motorhome, grow their own food, shop at thrift stores, and repair used items than work their lives away to support a consumer-oriented lifestyle.
It is not everyone’s cup of tea, but it is a viable lifestyle choice that many people choose to live.
Others might argue that an 8% investment return is an unrealistic assumption but the reality is, that it doesn’t matter. The time period is so short in these examples that the compound return has a minimal impact. You are saving your way to wealth – not compounding. The process is primarily dependent on the percentage savings rate – not the compound investment return.
Finally, you might argue with the 3% spendable income assumption but that won’t hold water either. You can build a portfolio of quality dividend stocks that pays 3% or greater right now, and history shows that income can be expected to grow faster than inflation – without ever touching principal.
In other words, you can argue all you want but the examples are realistic and viable. It is rock-solid and scientific. It works because it is so simple. People are putting it into practice every day and getting results with this formula.
However, extreme frugality may not work for you. Your values may be inconsistent with saving 70-80% of your earned income. If that is the case, then let’s see how you might apply these lessons to your own situation…
The Price You Pay For Not Being Frugal
In a nutshell, when you save less it takes longer to reach the goal. The longer you take the less certain the outcome becomes. More variables and complications get introduced.
Let’s examine how this works in greater detail…
- Staying with our previous assumptions, if you save 50% or $2,500 per month then you will need to overcome a $30,000 per year spending hurdle to become financially independent. It will take 17 years to accumulate $1,086,000 providing the needed $32,580 in annual income.
- If you save 25% or $1,250 per month you will have $1,436,000 in 27 years which would give you $43,080 in annual income – just slightly over the $40,000 you would be spending. In other words, 25% additional spending added 10 years to the process.
- Run the same math for 10-15% and you’ll find it takes 40-45 years to achieve the same result. This should come as no surprise since that is what most experts claim you should save assuming normal career longevity.
What quickly becomes evident is the direct relationship between the percentage savings rate and how many years it takes to retire with financial independence. The math is unequivocally clear.
- 80% = 7 years
- 70% = 10 years
- 60% = 14 years
- 50% = 17 years
- 40% = 21 years
- 30% = 26 years
- 20% = 32 years
- 15% = 37 years
- 10% = 42 years
What is less obvious is how the longer time periods in this second set of examples are not as reliable. When it takes you 17-45 years to reach your retirement goal the compound investment return plays a critical role in achieving the goal. Additionally, you must adjust for the erosive power of inflation to properly discount the purchasing power of your savings or you will deceive yourself.
In other words, you are no longer saving your way to financial independence – you are compounding your way there net of inflation. Both of these factors are a very big deal because small percentage changes in investment return and/or inflation multiply into huge changes in how much money you need to retire. It is a game changer.
So while the math remains unequivocally clear and the principles illustrated are undeniable, the outcome becomes less certain at longer time horizons. For short time periods you are essentially saving your way to wealth, but in longer time periods you are compounding your way to wealth. They are similar in principle but include important distinctions that must be accounted for.
In short, the savings process is simple and scientifically accurate: the compounding process is more complex and less certain.
It’s All About Your Values
In summary, it all boils down to your values and how motivated you are to tell your boss what he can do with that lousy job.
It is possible to retire in 7-14 years with mathematical certainty. There is no complication and very little to learn – except how to find happiness with a minimalist lifestyle.
Anyone can do it when they decide it is a high enough priority. Many people do it every day.
However, you will pay a price to live that way. You will spend much of your life energy focused on stretching every dollar. You will have to pay attention to the price of everything you purchase.
There’s nothing wrong with it. It’s just not necessarily the right path for everyone.
However, the alternative introduces new uncertainties. Inflation and compound investment return must be figured into long time frames for retirement. You must spend more of your life working in a job you may dislike for an outcome that is less certain.
In short, there are no easy answers. You will pay a price no matter which choice you make.
The key is to make a conscious choice that reflects your values and preferred lifestyle instead of ignoring the problem thus allowing inaction to make the choice for you.
Image Created by Meta AI
See Also:
- Improve Your “Save-ability”
- Budgeting Your Family Finances
- The Wealthy Buy Assets, the Poor Buy Liabilities, and the Middle-Class Buy Liabilities Believing They Are Assets
- Bad Financial Advice Abounds
About The Author – Todd Tresidder is a retirement coach who walked-the-talk and retired at age 35. You can learn more about his unconventional take on investing, financial freedom, and living with true wealth at financialmentor.com.
