How much money do I really need to retire early?

One of the most frequent questions I get from friends and family is, “How did you decide on your number?” In other words, how much money do you really need to retire early? The vast majority of personal finance experts will give the same answer: “It depends.”

I agree with that answer but disagree with their rationale. Also, since I hate non-answers such as “it depends,” I’ll say about $1 million multiplied by the number of people in your household. In other words, get somewhat rich. More on that later.

In my opinion, too many financial advisors impart a false sense of security by (1) assuming a “historical rate of return,” (2) assuming an average lifespan, and (3) assuming a drawdown to zero at the end of that average lifespan.

Do not assume a “historical rate of return” for your retirement fund

First, assuming a “historical rate of return” for your retirement portfolio can lead to devastating consequences down the road. (You can run out of money!)

The fact is, markets do not move in a predictable or linear fashion over the short-term, or sometimes even the medium term. In other words, the average rate of return for the time period in which you are retired may vary wildly from the average rate of return for the past couple of centuries.

For example, although the average annual return of the stock market has been 7% throughout its long-term history, there have been many, many decade-long periods in which it has returned significantly less than that.

Depending on your age and your level of expenses during a snapshot period in time, a 7% assumption could leave you in a precarious retirement predicament. Worse, it could tempt or cause you (or your financial advisor) to accept an unreasonably high level of risk in an attempt to “make up” for a period of low or negative returns. That, in turn, could leave you in a far worse situation if hoped-for returns do not materialize.

What is a reasonable rate of return?

So what is a reasonable rate of return? That depends on the prevailing rate of inflation. “Inflation” is just a fancy way of saying that, in general, your money loses its buying power over time and that things get more expensive to purchase over time.

In order to enjoy a comfortable retirement, your first investment objective must be to keep pace with the rate of inflation. As I write this post, the inflation rate is more or less in line with the historical average of about 2%. However, this is something to keep an eye on because there have been periods in which inflation rates have been much higher and lower (or even negative).

Reasonable minds can differ, and everyone has different risk tolerances, but in my mind, a reasonable rate of return is about three percentage points above the rate of inflation. In other words, under current conditions, a 5% rate of return is a reasonable goal. This target is achievable without undue risk, over most spans of time, except under the most extreme economic conditions.

Do not assume an average lifespan

Second, do not assume you will live to a particular age when calculating your retirement needs. This one is pretty straightforward. Average lifespans are just that. Average. Your actual lifespan may vary wildly from the average.

The reason financial advisors consider average lifespans is due to the third problematic rationale below.

Your retirement savings are not your retirement fund

Third, do not think of your retirement savings as your retirement fund. Instead, think of it as the golden goose that will lay golden eggs to fund your retirement. If you had a golden goose, you would never think of eating it, so why would you spend your retirement principal?

“Blue blood” families, “old money,” and the financial aristocracy in every place in the world teach their children one simple truth: “Never spend your principal.” Yet, for a variety of reasons I’m sure you can guess, financial advisors commonly advise their clients to assume a spend-down to near zero at death.

There are several reasons to avoid this line of thinking. First, it is quite possible to outlive your money; then what? Second, you have very low margin for error if you encounter unanticipated and unavoidable expenses such as uninsured medical bills. Third, you might die with very little or nothing to pass on to your loved ones, charities, causes, etc.

Finally, leaving such a low margin for error defeats the very spirit of retirement, during which you should be enjoying life on your own terms with minimal anxiety and worry.

To retire early, aim for about $1 million per person

So how much is enough? For most people in most parts of the U.S. with reasonable spending habits and tastes, $1 million per person for every member of your household should provide your family with a relatively comfortable life.

For a family of four, you should be able to achieve an average annual return of approximately $200,000 (which is more than double the average U.S. household income) from your starting principal of $4 million, assuming a 5% rate of return.

In all but the most expensive places in the U.S., you should be able to live comfortably on $200,000 per year, and you might even be able to increase your principal in the process (if you don’t spend all of your annual return).

YMMV: shoot for double the average household income in your retirement locality

As I stated above, $1 million per person is a very general guideline, and I’m also assuming that your household will generate zero income from other sources after retirement.

A more precise goal would be to amass enough retirement savings to generate double the average (not median) household income in your retirement area after taking into account any additional sources of income (e.g., alimony, inheritance, part-time work, etc.). Unless you have extravagant tastes or a penchant for overspending, you should be able to live quite comfortably on double the average household income.

Although the amount of money needed may vary from person to person, the larger point is to remember the spirit of full or partial retirement, which is to live life on your own terms without significant financial worries or boundaries.

That doesn’t mean you will have no worries or boundaries, or that you will be able to buy whatever you want, whenever you want. That level of extreme wealth isn’t the balance I’m trying to help you to achieve, nor is it necessary for early retirement.

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