My title was said a bit sarcastically but there really is a magic formula to becoming financially independent and/or to retire early
How to retire in 5 easy steps
Step 1: Start saving as soon as you start earning income.
Step 2: Do not get into debt (or get out of debt as quickly as possible if you are in debt)
Step 3: Save at least 10% of every paycheck and put it in an Individual Retirement Account (IRA)
Step 4: Diversify your investments
Step 5: Continue steps 2-3 for about 40 years
If you set aside more that 10% of your income or you do especially well in your investments you could reach FIRE (financial independence / retire early) much earlier than 40 years - but everyone should be able get there with this formula.
Step 1: Start saving as soon as you start earning income.
You have probably heard about "compound interest." In case you haven't or as a refresher, it is simply that your saved money earns interest over a period of time and that as that interest is paid, that interest then ALSO earns interest.
If you invest in the stock market, your investments on average earn about to 10.5% return per year. With compound interest at this rate any investment will double in value in about 7.5 years. Over the period of 40 years you're initial investment will double about 4.5 times. So if you started with a $1000 investment this is how much it would be worth after the given amount of time:
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Holy smokes, our measly $1000 turned into $64,000 over 45 years!
This chart show us the most important point of compound interest, that the most important investment is your very first investment! This is the money that earns the most compound interest. If you waited 7.5 years before making that first investment, then you would only get $32,000 on the backend! It would mean that your own procrastination LOST 1/2 of your retirement money.
In trying to retire, you either fight time or use it as an ally.
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Step 2: Do not get into debt (or get out of debt as quickly as possible if you are in debt)
The very power of compound interest in your savings account works against your when you're in debt. In fact, the credit card company (or mortgage company or student loan company or automobile finance company) is using YOU as a source for THEIR compound interest savings!
In general debt is toxic to you and your retirement planning - avoid it when possible. If you must take on debt, discharge it as soon as you can.
I must admit at this point that under certain circumstances debt can be beneficial. The best way of determining whether debt is good or bad is by determining whether the debt is to acquire an appreciating asset (one which gains in value) or a depreciating asset (one whose value declines over time).
The evaluation is still not done though. An asset that appreciates in one period of time or for one person may be a depreciating asset for another. The recent real estate markets should provide plenty of support for my assertion!
But also consider student loan debt. Taking on $100,000 in debt to acquire a degree in teaching (which doesn't pay very well) from an Ivy League school would be a BAD investment. Going to a state school to get a degree in a field which would significantly improve your earning is usually a good investment.
Nearly all consumer debt (for things such as electronics, cars, eating in restaurants, etc.) is BAD debt. If you don't already have the money to buy these things - then do NOT buy them with debt. An exception could be made to purchase a car so that you can get to your place of employment but buy a cheap vehicle and pay back the loan as soon as possible!
For more of my thoughts on debt, you can go to my previous blog on the subject. It isn't as well organized as this and I may go back and tidy it up if people express some interest in it.
Back to the top
Step 3: Save at least 10% of every paycheck and put it in a retirement account (IRA or 401K)
Of course we're not going to just rely upon the compound returns of just our initial year's savings. A more realistic scenario would be that we continue saving each year. In that case our savings profile will look more like this:
Cool, over 45 years we turned $45,000 ($1000 per year for 45 years) into nearly $950,000!
If your savings amounts to $10,000 per year instead of $1000, then you would multiply this number by 10 ($9,500,000!!). If you're making $50,000 per year and are saving $5000 per year, then multiply this number by 5 for about $4,750,000 in savings.
A quick but important addendum to this is that if your employer offers a 401K plan in which the employer contributes to your 401K, then ALWAYS put in enough of your own money to get ALL of the employers match. In life, you'll almost never encounter a situation in which you can get "free money" but this is one of those very rare cases for which you do get something for nothing.
I want to reiterate this point. Even if you have to immediately turn around and take your contribution out (this incurs penalties and I don't recommend doing it BUT if you must do so, you'll still do better by getting your employers contribute and living with the penalty).
Back to the top
Step 4: Diversify your investments
Earlier I mentioned that historically, stocks have earned an average rate of return of about 10.5%. However, most of you recall that stocks semi-periodically suffer from "market meltdowns", "black Fridays", or "crashes." In fact all asset classes (precious metals, treasuries, bonds, real estate, etc.) suffer from similar behavior (sudden rises in prices and soul crushing falls). However, it is nearly impossible for all asset classes to move in the same direction at the same time.
So the best means of protecting the capital value of your savings is to "diversify" your retirement across many asset classes. To do this you decide what percent of your money belongs in each class. Then when one asset class loses or gains value then rebalance your portfolio back to the correct proportions. This forces you to sell some assets after they've risen in value and buy others when they have lost value.
Your next question is going to be, "so what are good asset proportions?" That's a VERY good question and one that depends a lot upon a person and their tolerance for risk. A formula that works well for most people is (100 - your age) for how much you should invest in stocks as a percent of assets. The rest should be invested in bonds + savings accounts as a percent of assets.
As an example, I'm 44 years old. Using my formula indicates that 56% of retirement savings should invested in stocks. However, I personally am willing to accept more than average risk and actually have about 65% (or more!) invested in stocks. In normal times I would split the remaining 35% roughly equally between savings and bonds - but these are normal times (I don't trust the bond market right now).
Back to the top
Step 5: Continue steps 2-3 for about 40 years
As I pointed out in Step 1, the best ally you have for saving up enough money to retire is time - but only if you start early. If you start saving when you're 20, it won't be very hard for you to save enough to retire by the age of 60.
However, if you start late, then you'll struggle to save enough to retire. You can compensate for starting late, by working later into your life -OR- by allocating more of your income for retirement savings. In fact saving more for retirement helps in two ways - by actually putting more into your retirement accounts BUT also by getting you used to living with less.
Doubling the money you set aside will double the money available when you go to retire, it's a very linear relationship.
But if you can life on 80% of your income instead of 90% of your income, you have also reduced the amount of savings you will need when you retire.
Which brings me to another question I forget to mention, "how much money do you need to retire?"
The general answer is figure out how much you earn now, and the annual amount you'll need to retire will be about 80% of this value (or 70% if you're able to put aside 20% of your income). Now there's a whole smorgasbord of assumptions that go into that pronouncement - the most important being that there will be no inflation (which is a VERY bad assumption!).
But for sake of argument, let's say you earn $50,000 per year and can save 10% of your income per year (that's $5,000). When you go to retire, you'll need about $40,000 per year for retirement.
Now a bunch of very smart people have invested a lot of time to determine how long retirement investments can last after we start drawing them down. The magic number they have derived is 4% - you can withdraw up to 4% of your retirement investments per year and maintain a 95%+ chance that your money will last 30 years or more.
So to figure out how much you need, divide the $40,000 per year by 4%. The number you'll get is $1,000,000. Yup, your math isn't wrong, you'll need to be a millionaire these days in order to even contemplate retiring.
Saving for retirement may be aided a bit by Social Security, but you should not count on that.The Obama administration is currently "floating" several ideas. Some of these include:
"means testing", meaning if you have saved money for retirement, you will not get Social Security
"reducing benefits", meaning giving future retirees significantly lower benefits than current retirees
"confiscating 401Ks", meaning he has suggested that the federal government will take ALL current 401K assets from workers.
I will make one further observation about Social Security and that is Congress can (and has) changed Social Security's rules at any time. If they decide only Congressmen are eligible, then that's the final word.
Back to the top
Proceed to my next blog on finances called what you should do this week
How to retire in 5 easy steps
Step 1: Start saving as soon as you start earning income.
Step 2: Do not get into debt (or get out of debt as quickly as possible if you are in debt)
Step 3: Save at least 10% of every paycheck and put it in an Individual Retirement Account (IRA)
Step 4: Diversify your investments
Step 5: Continue steps 2-3 for about 40 years
If you set aside more that 10% of your income or you do especially well in your investments you could reach FIRE (financial independence / retire early) much earlier than 40 years - but everyone should be able get there with this formula.
Step 1: Start saving as soon as you start earning income.
You have probably heard about "compound interest." In case you haven't or as a refresher, it is simply that your saved money earns interest over a period of time and that as that interest is paid, that interest then ALSO earns interest.
If you invest in the stock market, your investments on average earn about to 10.5% return per year. With compound interest at this rate any investment will double in value in about 7.5 years. Over the period of 40 years you're initial investment will double about 4.5 times. So if you started with a $1000 investment this is how much it would be worth after the given amount of time:
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| Years | Value |
| 0 | $1,000 |
| 7.5 | $2,000 |
| 15 | $4,000 |
| 22.5 | $8,000 |
| 30 | $16,000 |
| 37.5 | $32,000 |
| 45 | $64,000 |
Holy smokes, our measly $1000 turned into $64,000 over 45 years!
This chart show us the most important point of compound interest, that the most important investment is your very first investment! This is the money that earns the most compound interest. If you waited 7.5 years before making that first investment, then you would only get $32,000 on the backend! It would mean that your own procrastination LOST 1/2 of your retirement money.
In trying to retire, you either fight time or use it as an ally.
Back to the top
Step 2: Do not get into debt (or get out of debt as quickly as possible if you are in debt)
The very power of compound interest in your savings account works against your when you're in debt. In fact, the credit card company (or mortgage company or student loan company or automobile finance company) is using YOU as a source for THEIR compound interest savings!
In general debt is toxic to you and your retirement planning - avoid it when possible. If you must take on debt, discharge it as soon as you can.
I must admit at this point that under certain circumstances debt can be beneficial. The best way of determining whether debt is good or bad is by determining whether the debt is to acquire an appreciating asset (one which gains in value) or a depreciating asset (one whose value declines over time).
The evaluation is still not done though. An asset that appreciates in one period of time or for one person may be a depreciating asset for another. The recent real estate markets should provide plenty of support for my assertion!
But also consider student loan debt. Taking on $100,000 in debt to acquire a degree in teaching (which doesn't pay very well) from an Ivy League school would be a BAD investment. Going to a state school to get a degree in a field which would significantly improve your earning is usually a good investment.
Nearly all consumer debt (for things such as electronics, cars, eating in restaurants, etc.) is BAD debt. If you don't already have the money to buy these things - then do NOT buy them with debt. An exception could be made to purchase a car so that you can get to your place of employment but buy a cheap vehicle and pay back the loan as soon as possible!
For more of my thoughts on debt, you can go to my previous blog on the subject. It isn't as well organized as this and I may go back and tidy it up if people express some interest in it.
Back to the top
Step 3: Save at least 10% of every paycheck and put it in a retirement account (IRA or 401K)
Of course we're not going to just rely upon the compound returns of just our initial year's savings. A more realistic scenario would be that we continue saving each year. In that case our savings profile will look more like this:
| Years | Investment Value |
| 0 | $1,000 |
| 7 | $11,646 |
| 15 | $37,531 |
| 22 | $85,131 |
| 30 | $200,874 |
| 37 | $413,707 |
| 45 | $931,229 |
If your savings amounts to $10,000 per year instead of $1000, then you would multiply this number by 10 ($9,500,000!!). If you're making $50,000 per year and are saving $5000 per year, then multiply this number by 5 for about $4,750,000 in savings.
A quick but important addendum to this is that if your employer offers a 401K plan in which the employer contributes to your 401K, then ALWAYS put in enough of your own money to get ALL of the employers match. In life, you'll almost never encounter a situation in which you can get "free money" but this is one of those very rare cases for which you do get something for nothing.
I want to reiterate this point. Even if you have to immediately turn around and take your contribution out (this incurs penalties and I don't recommend doing it BUT if you must do so, you'll still do better by getting your employers contribute and living with the penalty).
Back to the top
Step 4: Diversify your investments
Earlier I mentioned that historically, stocks have earned an average rate of return of about 10.5%. However, most of you recall that stocks semi-periodically suffer from "market meltdowns", "black Fridays", or "crashes." In fact all asset classes (precious metals, treasuries, bonds, real estate, etc.) suffer from similar behavior (sudden rises in prices and soul crushing falls). However, it is nearly impossible for all asset classes to move in the same direction at the same time.
So the best means of protecting the capital value of your savings is to "diversify" your retirement across many asset classes. To do this you decide what percent of your money belongs in each class. Then when one asset class loses or gains value then rebalance your portfolio back to the correct proportions. This forces you to sell some assets after they've risen in value and buy others when they have lost value.
Your next question is going to be, "so what are good asset proportions?" That's a VERY good question and one that depends a lot upon a person and their tolerance for risk. A formula that works well for most people is (100 - your age) for how much you should invest in stocks as a percent of assets. The rest should be invested in bonds + savings accounts as a percent of assets.
As an example, I'm 44 years old. Using my formula indicates that 56% of retirement savings should invested in stocks. However, I personally am willing to accept more than average risk and actually have about 65% (or more!) invested in stocks. In normal times I would split the remaining 35% roughly equally between savings and bonds - but these are normal times (I don't trust the bond market right now).
Back to the top
Step 5: Continue steps 2-3 for about 40 years
As I pointed out in Step 1, the best ally you have for saving up enough money to retire is time - but only if you start early. If you start saving when you're 20, it won't be very hard for you to save enough to retire by the age of 60.
However, if you start late, then you'll struggle to save enough to retire. You can compensate for starting late, by working later into your life -OR- by allocating more of your income for retirement savings. In fact saving more for retirement helps in two ways - by actually putting more into your retirement accounts BUT also by getting you used to living with less.
Doubling the money you set aside will double the money available when you go to retire, it's a very linear relationship.
But if you can life on 80% of your income instead of 90% of your income, you have also reduced the amount of savings you will need when you retire.
Which brings me to another question I forget to mention, "how much money do you need to retire?"
The general answer is figure out how much you earn now, and the annual amount you'll need to retire will be about 80% of this value (or 70% if you're able to put aside 20% of your income). Now there's a whole smorgasbord of assumptions that go into that pronouncement - the most important being that there will be no inflation (which is a VERY bad assumption!).
But for sake of argument, let's say you earn $50,000 per year and can save 10% of your income per year (that's $5,000). When you go to retire, you'll need about $40,000 per year for retirement.
Now a bunch of very smart people have invested a lot of time to determine how long retirement investments can last after we start drawing them down. The magic number they have derived is 4% - you can withdraw up to 4% of your retirement investments per year and maintain a 95%+ chance that your money will last 30 years or more.
So to figure out how much you need, divide the $40,000 per year by 4%. The number you'll get is $1,000,000. Yup, your math isn't wrong, you'll need to be a millionaire these days in order to even contemplate retiring.
Saving for retirement may be aided a bit by Social Security, but you should not count on that.
"means testing", meaning if you have saved money for retirement, you will not get Social Security
"reducing benefits", meaning giving future retirees significantly lower benefits than current retirees
"confiscating 401Ks", meaning he has suggested that the federal government will take ALL current 401K assets from workers.
I will make one further observation about Social Security and that is Congress can (and has) changed Social Security's rules at any time. If they decide only Congressmen are eligible, then that's the final word.
Back to the top
Proceed to my next blog on finances called what you should do this week
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