Tuesday, January 19, 2010

Do You Need 60X Annual Expenses to Retire Early?

Three years ago, I published a post titled The Millionaire's Rule of Thumb which presented an often quoted formula for expected net worth based on age and income. Many readers have expressed their dissatisfaction with the formula which is attributed to the book, The Millionaire Next Door by Thomas Stanley and William Danko. I predicted that someday a reader would develop a new and improved formula.

Three years to the day after I first posted that article, a reader who goes by the name of "dunkelblau" has indeed come up with a new and improved formula! Below is summary of dunkelblau's comments taken from this post, and from my very popular Net Worth Update post. (Note: Comments have been edited.)

I agree that wealth should be measured in units of time rather than dollars -- as in how long you can holdout without any wage income. But the correct denominator is annual expenses, not annual income. You're ready to retire when your networth divided by your annual expenses reaches 100 minus your age in years.

I don't blame you if you didn't catch that.  What the reader is saying is that if you take your net worth and divide that by annual expenses, that should equal 100 minus your age. The reader refers to net worth as the "numerator" and annual expenses as the "denominator". Reading on, dunkelblau continues by saying:

Investing well increases the numerator, but even investing badly still shrinks the denominator (assuming you don't borrow to invest). I think a conservative target number [for this quotient] is 100 minus your age in years. This way there's little chance of outliving your money.

So, as further clarification, another way to say this is that your net worth should equal your annual expenses times (100 minus your age):

Net Worth = Annual Expenses * (100 - age)

Lets take the example of a 40 year old who has saved $1 million for retirement. If this person can reduce expenditures to $40,000 per year, a common rule of thumb is that one can live off of the $1 million saved by assuming a conservative 4% safe withdrawal rate. See Resources for Early Retirement.

However, the "new and improved" wealth formula dictates that one needs (100 - age) times annual expenses to retire. In the case of a 40 year old, that would be 60X annual expenses, or a whopping $2.4 million for this individual to retire! Conversely, this person could further reduce their spending to less than $17,000 per year in order to live off of the $1 million. No wonder people assume that early retirement is impossible! The other curious thing about this new "formula" is that as one ages, the expected net worth actually goes down if annual expenses are kept constant. The one thing that I agree with dunkelblau about is that if you follow this formula, there is little chance of outliving your savings.

Anyway, my common sense tells me to take dunkelblau's formula with a grain of salt. In my opinion, this is definitely a new formula, but where is the improvement? What do the readers think?


1 comment:

dunkelblau said...

Wow, you made my day! Let me try to defend my position on this formula.

First, I think the main improvement is the idea that expenses matter more than prior income, so at least in my opinion we have better variables with this equation. If you become accustomed to living on lower expenses, the original income-based
formula shows no benefit, while this new one says you're effectively richer for a given dollar net worth. Intuitively I believe it to be true, and it's one of the hidden benefits from a high savings rate.

Next, there are no terms for inflation or returns, and the assumption here is that investments will return enough to yield a couple of per cent after taxes and inflation. It's also assuming that you want to keep most of that nest egg to bequeath to heirs or in case perchance you live much longer than you expect. This means that the safe withdrawal rate varies by age-- it is small if you retire young and loosens up the older you retire. Effectively this drawdown would be the inverse of 100 minus your age in years, expressed as a percent, so if you kick back at 40, your initial rate would be 1.67% while if you work till a more typical 60, it would be 2.5%. Note that this would be disposable income.

These percentages I personally would feel more comfortable using-- in my view giving up a paycheck to depend on a 4% withdrawal rate to cover living expenses is risky, not conservative. Granted times like these won't last forever, but I'm not sure I'd rule out the possibility that low CD yields last more than just a few quarters. Anyway an easy adjustment to this formula would be to change the 100 to maybe 80, and the withdrawal percentages would increase to 2.5% and 5% for 40 and 60 year olds. This also shrinks target net worth quite a bit unless you're retiring very young.

Finally this formula only applies up to maybe 95% of the maximum age factor. Centenarians are wonderful people but not even they can live off of a negative net worth!