Reflections on the Nielsen's Early Retirement

"The trouble with retirement is that you never get a day off."
- Abe Lemons

Over the past few years, I've read many personal stories about early retirement. Unfortunately, in most cases the story details didn't resonate very much with me. Sometimes the person in question retired after a supreme event of good fortune, such as receiving a large inheritance or cashing out of a hugely successful stock option grant at one's place of employment. In other cases, it appears that a career change was redefined as "early retirement". (e.g. "I accumulated almost $100,000 and then retired early. Soon after that, I was bored so I started earning money in a different line of work six days a week, and now with that extra income, I'm really enjoying early retirement more than ever." Huh?)

Other articles describe an "extreme" lifestyle where someone lives on $7,000 a year or some similar number. Still other articles feature someone who does not have a plan but merely "hopes to retire early". And then there are the occasional self-serving articles where the person in question "retired early" by writing a book about how to retire early.

All these articles had some entertainment value for me, but they didn't resonate with me because I could not imagine myself in a similar situation or relate to them in any meaningful way. However, a recent Money magazine article about a military family who retired early really struck a chord with me.

On the surface, the family in the article seems much different than my family. They live in the midwest. We live in the Northeast Corridor. They worked in the military. We have always been civilians. Their primary source of retirement income will be their combined pensions. Our primary source of income retirement income will be stock dividends. They will have lifetime medical benefits provided by the government. We will need to pay for medical expenses. On the other hand, it appears they are starting retirement with many years on their mortgage, while we will probably be mortgage free when we start retirement. We also have a sizable sum earmarked for our kids for college, while this is still a big concern for them. Additionally, we don't share the same family backgrounds, the same occupations, or even the same hobbies.

Yet a closer examination reveals a whole host of financial and lifestyle similarities between our two families:

• Early retirement was a conscious, but evolving, plan over 15-20 years.


• The success of the plan mainly depended upon consistent execution.


• Frugality was important, but was never taken to extreme levels. Consistency in all areas for long periods of time was more important than a few spectacular penny-pinching maneuvers.


• They adhered to a budget for long periods of time.


• Their spending level is in the general ballpark of what we are planning.


• Interestingly enough, upon discussing the possibility of early retirement with friends, we have also experienced the same two negative reactions from many people: (1) You're going to be bored. (2) You're being quite irresponsible.


• Career success was a reasonably large factor, but their strategy did not require an extensive climb up the ladder.


• They saved about 35% of their income at first, and even more as retirement approached.


• They invested mainly in equities.


• They felt like quitting many times, but ultimately persevered.

In addition to a modest $400K in savings, they can also draw about $60K / year from their military pensions, which are adjusted up for inflation each year. While a pension seems intangible to many people, a pension is just an annuity stream and one can easily calculate its value. Using publicly available annuity quotes from Vanguard, I attempted to put a value on their military pensions. Here are the results:

• Male; Age 44.5; Missouri resident
  
• Annuity income = $36,900


• Paid monthly ($3,075/month)


• Adjusted for inflation (yearly to CPI)


• Value of annuity:
  
• $955,982 (Single Life)
• $1,044,396 (Joint / 50% survivor benefit)
• $1,132,810 (Joint / 100% survivor benefit)



• Female; Age 40.5; Missouri resident
  
• Annuity income = $36,900


• Paid monthly ($1,800/month)


• Adjusted for inflation (yearly to CPI)


• Value of annuity:
  
• $629,494 (Single Life)
• $646,343 (Joint / 50% survivor benefit)
• $663,193 (Joint / 100% survivor benefit)
  

Depending on the survivor benefits chosen, the total value of both annuity streams is worth somewhere between $1.6 to $1.8 million. Again, just as our projected spending level is similar to theirs, our projected necessary wealth accumulation is (perhaps unsurprisingly) also in the same ballpark.

Congratulations to the Nielsens. If all goes well, we hope to be joining them in about 5 years.

80% Redux

"The same conclusion may be reached from a different premise."

- James Henry Ferguson, The Philosophy of Things

The Journal of Financial Planning has just published an article by Ibbotson which discusses savings guidelines and capital needs for retirement. Although it is certainly not light reading, the article is well written and definitely contains some interesting information. What fascinated me most is that the authors arrived at nearly the same numbers that I did through entirely different means.

• Retirement needs. The article suggested using 80% of "pre-retirement net income", which was defined as gross income less retirement savings. In a previous post, I explained why I don't think I'll need 80% of my pre-retirement income, and I suggested that retirement needs should simply reflect consumption level at retirement. However, I must admit that when I calculate my expected needs based on the Ibbotson formula, it does come out very close to my original calculations based on consumption.
  
• Savings guidelines. The article used Monte Carlo simulations to estimate the required savings rate one would need to build enough capital to provide for retirement needs. Interestingly enough, the article came very close to the personal savings rate I eventually chose mainly through intuition as I watched my net worth grow.
  
• Social Security. The article also discusses the non-linearity of Social Security benefits, which are skewed toward lower-income individuals. The article advises higher-income individuals to save at higher rates in order to compensate for this effect. This is not unreasonable advice. However, I also mention in a previous post about early retirement and Social Security that non-linearity and other aspects of the Social Security benefit formulas mean that higher-income individuals do not lose as much when considering early retirement.

Why I Won't Need 80%

"If people do not believe that mathematics is simple, it is only because they do not realize how complicated life is."

- John von Neumann

The rule of thumb from the financial experts is that you will need to replace 80% of your pre-retirement income in order to maintain the same standard of living when you retire. I suppose that figure may be true for some people, but it clearly won't be the case for me.

The first thing to realize is that after retirement, I won't need to be saving money, so the percentage of my income that I have been saving each year won't now be needed to support my standard of living. And if you retire early, of course, it's a good bet that you had a high savings rate which enabled you to get there so soon. For me, I've been saving around 40% of my income for quite a while, so simply dropping the need to continue to save money would by itself reduce my "magic number" to 60% of pre-retirement income.

Second, after retirement I won't be paying Social Security and Medicare tax on my income because at that point, the sources of my income (i.e. interest, dividends, capital gains, and pensions) won't be considered earned income. This saves another 7.65%, and puts the magic number close to half of pre-retirement income.

Third, a drop in income to one half of my pre-retirement income means a significant reduction in my Federal and State income taxes. This further reduces the percentage of pre-retirement income needed.

Ultimately, I believe my income level at retirement is a poor proxy for my retirement needs. A better choice would be to use my consumption level at retirement. For many people, income level is unfortunately roughly equal to consumption level, so in that case, income may provide a close approximation to consumption and I believe that is probably the origin of the 80% rule of thumb.

Lastly, I would be remiss if I painted the entire story as good news. For while I believe that the required initial level of retirement income is often grossly overestimated, I also believe that the required growth of retirement income is often severely underestimated. I have compiled a number of anecdotal measures of inflation from my own personal experience and the results are not pretty.

Much of my retirement planning for the last several years reflects this reality. Most of my portfolio strategy is centered around dealing with two problems: the order of investment returns and inflation. I hope to address these issues in detail in futures posts.