When can you give up the security of a regular paycheck?

This is a fundamental question that everyone must eventually answer in the context of their own “retirement”.  I put “retirement” in quotes because what we are really talking about is not necessarily retirement in the conventional sense. Instead, the goal might be better stated as attaining the level of financial independence that is needed to make a regular paycheck optional.  You might like your job and have great relations with your boss today, but that could always change tomorrow or next month.  A recession could result in layoffs and you might find yourself involuntarily out of work.  Illness has been the cause of many premature exits from the workforce.

At what point are you immune from having to worry about drawing a paycheck?

Nassim Nicholas Taleb should be credited with the concept of “F*** You Money” that he developed in The Black Swan and has elaborated on numerous times since the book was published.  To state the obvious, not everyone works for a pointy-headed boss and hates their job as much as Dilbert and Wally, and plenty of people actually love their job and enjoy the people they work with.  Whether or not you like the language used by Scott Adams, Nassim Taleb, or John Goodman, the point is obvious:  When can you declare independence from paid employment if you choose to do so?

At the risk of stating the obvious, there are two major factors that we need to look at:

  1. How much money is needed to fund your lifestyle every year?  The answer is not as simple as looking at what you are currently spending every year.  There will almost certainly be expenses related to work that will entirely disappear from your budget if you choose to leave paid employment.  You will no longer have to commute to work so the cost of driving or public transit will disappear.  Maybe you can even give up your car entirely.  It will be unnecessary to purchase clothing specifically for work.  If you aren’t packing a lunch for work almost every day, you are probably spending a lot of money on eating out and that could be eliminated as well.  This list isn’t exhaustive.  On the other side of the equation, you will incur new expenses in “retirement” such as the cost of health insurance, which is likely to be the largest new big ticket item.  Also, you will have more time to travel and pursue recreational activities.  You could very well end up spending more money in “retirement”!
  2. How much money have you saved?  This is obviously simpler to answer but I don’t think that it can be distilled into a single number.  Most importantly, it is critical to differentiate between assets that are accessible and assets that are locked up for an extended period of time.  If you are 40 years old and contemplating giving up your paycheck, what matters for the foreseeable future is the amount of liquid assets that you have in non-retirement accounts.  You do not want to even contemplate touching retirement funds in a 401(k) or IRA because early withdrawal penalties are significant for anyone who is younger than 59 1/2 years of age.  You also do not want to consider any form of home equity as a source of liquidity unless you are planning to downsize to a smaller home in retirement.

If you read enough personal finance articles, you probably have already come across discussions of “safe withdrawal levels”.  The idea of a safe withdrawal level is to calculate the amount of money that can be withdrawn from an investment portfolio on an inflation adjusted basis over a specific period of time without running a significant risk of depleting all of your assets.  There are usually a number of embedded assumptions that are made in studies of safe withdrawal levels, such as the percentage of assets invested in stocks versus bonds and whether the stocks are invested in an index fund.  Typically, safe withdrawal levels are contingent upon a certain stock/bond mix and broad diversification of a portfolio.

The Four Percent Rule

Over the past two decades, the idea of the “Four Percent Rule” has spread quite widely.  The idea is that one can withdraw four percent of an investment portfolio in the first year of retirement and subsequently withdraw the same amount adjusted for inflation every year.  The inverse of the four percent rule is that one needs to have savings equivalent to 25 times annual spending requirements in order to safely retire.  So, if you have calculated that you need to have $50,000 available for spending in the first year of retirement, you would need to have an investment portfolio of $1,250,000 to support that level of withdrawal in a “safe” manner.

When I first started thinking about the concept of early “retirement”, I spent quite a bit of time researching the topic of safe withdrawal rates and came upon a study that went quite a bit deeper than the four percent rule.  I am not going to link to the study because it has not been updated since 2001 and generated some subsequent controversy regarding the methodology that was used.  However, at the time it was the most comprehensive look at safe withdrawal levels that I had come across.  The study looked at financial market returns from 1871 to 2000 and projected the safe withdrawal level for various payout periods based on past history.  A reader could pick their projected payout period and find the optimal mix of stocks versus bonds that would generate a “100% safe” withdrawal level.

The payout periods ranged from ten years, which would only be appropriate for someone who is either already very old or in poor health, to sixty years which was more appropriate in my situation since I was in my thirties at the time.  I found that the safe withdrawal rate for a sixty year payout was 3.24 percent with a 85%/15% split between stocks and bonds.

The study examined 70 periods from 1871 to 2000 in order to come to the conclusion that a 3.24 percent withdrawal level could be safely sustained for sixty years, with withdrawals rising each year with inflation.  In the vast majority of cases, there would be a very substantial portfolio left at the end of the sixty years. In fact, the median result was that every $1,000 of value in the initial portfolio would end up being worth nearly $43,000 after 60 years assuming a yearly withdrawal of 3.24 percent of the initial portfolio rising each year with inflation.  The worst possible result was that the portfolio would be effectively depleted.

But the main problem with safe withdrawal level studies is that they are backward looking.

It is a major logical fallacy to assume that the next sixty years will look like the period that spanned 1871 to 2000, or anything like it at all!  This is obvious, but it is tempting to look at an overly precise number like “3.24 percent” and assign it with more certainty than it deserves.

No one has any idea what the future will bring or what investment returns will look like, but if we want to make any kind of estimate regarding financial independence, we have no choice but to at least try.  This exercise calls for a great deal of conservatism.  I am not comfortable with the four percent rule, and not really comfortable with the 3.24 percent figure that came out of the study.  Part of this is because of the fact that interest rates have been at an unusually depressed level in recent years.  In addition, the level of the stock market implies an “earnings yield” that is below average.  In a world of savings deposits earning next to nothing, a ten year treasury note yielding just 2.7 percent, and stocks trading at high valuations relative to the past, is it really conservative to look at a four percent withdrawal rate as a sure thing?  Would you bet your financial future on it?

The Three Percent Rule

I am not going to propose any specific rule for readers to follow, but I will say that I am comfortable with a three percent withdrawal rate and that is the rate that I initially used when considering my own financial independence, although my present withdrawal rate is far lower.  This rule implies that you would need to save a little bit over 33 years of annual expenses in order to consider yourself financially independent.  That’s obviously more than the 25 years that is implied by the four percent rule, but it is much more conservative.

Many people would criticize this approach as far too conservative, but is that such a bad thing?  Sure, you might have to save for a longer period of time to achieve independence, but once you do, the level of stress over withdrawal rates will be much lower.  Also, I’ve read criticism of low withdrawal rates along the lines of ending up with “too much” savings at the end of the withdrawal period.  This line of criticism is based on the idea that something big is being given up by under-spending for many years and that ending up with a large account balance in old age is a negative.  I think this is somewhat absurd for a number of reasons.  First, old age involves facing vicissitudes that younger people might not think of, especially when it comes to nursing care.  Having a pile of cash available to make life comfortable would hardly be unwelcome.  Second, most people want to leave some kind of legacy to family members and providing financial security to others in old age is hardly a negative.  Finally, you can always give away money.  There’s value in generosity and the knowledge that one’s savings can generate benefits beyond personal consumption.

The Bottom Line

The subject of safe withdrawal levels has not been a personal concern for quite some time as the level of my annual spending has declined well below any plausible “danger zone” as a percentage of my available investment assets.  I would suggest that using a three percent initial withdrawal level is far more reasonable than the much more commonly advocated four percent level and this would imply setting a target of about 33 times annual expenses as a goal for financial independence.

The other factor that should be noted here is that the lower your annual spending requirements, the sooner you can reach financial independence.  Perhaps that is obvious, but it might not be widely understood.  Too many people think about financial independence in terms of replicating their current income in retirement.  This is the wrong way to look at it.  For example, let’s say that you earn $150,000 per year but are only consuming $40,000 per year, which you expect to remain relatively constant in retirement.  You do not need to replicate a $150,000 income in retirement.  You only need to ensure that you can safely withdraw $40,000 per year from your portfolio, and that you can increase this figure each year at the rate of inflation.  Using a three percent rule, this would imply a required portfolio of a little over $1.3 million, which is less than nine times your current $150,000 annual income.

Obviously, no one want to live some horribly restrictive lifestyle either while employed or in retirement, but what is “horribly restrictive” for one person might represent luxurious living for another. Even for those who enjoy their paid employment and plan to continue working for others for decades could benefit greatly from financial independence and the peace of mind that makes work optional.

Note to readers: A version of this article originally appeared on The Spartan Spendthrift which I created a few years ago. I am planning to merge some of the existing content of The Spartan Spendthrift into The Rational Walk and to post future articles on personal finance here. It is easier to maintain only one website for all of my writing. 

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