A post at MMM, and an unexpectedly dreadful week moneywise, has got me thinking about how much of a safety margin we'll need to retire. I'm assuming most of you don't quit the minute your SWR surpasses your expenses. What kind of margin makes you comfortable? Will it increase or decrease with age?
If you have kids/plan to have kids--do you increase it while they're home, and decrease it when they move out? Or doesn't that factor in?
I have not reached my retirement amount yet, so I can't tell you from experience. However, I plan on having a very large safety margin, as there are just too many major problems that can drain your savings.
Plus, I can earn more now than I could 10 years after retirement, so I'm going to work the hours now.
First, I accept that there is no security and that although money is nice it’s a mistake to trust money. For a safety margin, I like about $25000 in cash money market over investment capital at 4%. Other safety margins include:
Amortization: For a financial safety margin, it depends on age at retirement and life expectancy, the latter of which is unknowable, i.e., if I die next week I saved way, way too much. Although I start with the 4% SWR, I like to take savings/investments and treat them as a mortgage amortized over life expectancy at a very low interest rate. If life expectancy is 30 more years, 500,000 at 1% over 30 years is $1608.20 per month, or $19, 298.40 per year even leaving it in the bank. This approach is mostly psychological but still helpful. Inflation can kill the value of the payments, but I am assuming that interest rates would rise as well.
Social Security: I think it will be there in some form, and even if the benefit is reduced in real terms to 25% of what’s currently promised, it can make up for a substantial amount of savings. If the current promise is $2000 per month, and you end up getting $500 per month in today’s dollars, that still makes up for $150,000 in savings at 4% withdrawal.
Insurance: The big things that can drain savings such as liability, medical bills, long term care, are insurable. Including premiums within the retirement budget is as good as increased savings to pay for them.
Family and community: This is a two way street, and provides another measure of safety. I’ve made substantial gifts to family over the years, and although most have since died, those remaining are doing well and we can help one another in an emergency.
Flexibility: The ability to reduce money expenses is better than just more savings IMO. Preparing a crash budget and a plan provides some added level of safety.
Ability to Earn Money: This is also a safety margin. As Jacob points out, a minimum wage job could support his life. Much better IMO to be able to freelance to get money if the need arises; retirement doesn’t mean being helpless.
For several reasons our retirement money will become available to us in stages, so the older we get the more we will have. Our ability to retire early now primarily depends on our ability to save diligently in non-retirement accounts... hence some of my recent posts.
To answer your question more specifically: after running our numbers for a year now, I would not be comfortable with anything less than a 25% margin UNLESS I intended to continue to generate that amount or more in income once I was "retired." That should put you in a good position to respond to whatever comes your way no matter how old your kids are.
My minimum requirement is that FireCalc says that I have zero probability of running out of money. I would prefer to have the FireCalc minimum plus enough money to support an additional $5k per year.
So, when I ERE, I do not plan on touching the money at all. Instead, I'd like to live off income from side businesses (landlording), odd jobs and personal projects.
Thanks for the link Jacob. I liked the amount of detail he gave. The effects of sequencing always surprise me. I understand the math completely, it's just shocking to see how a few bad years/choices at the beginning can run the whole portfolio right into the ground.
Since I have a pension coming to me in less than a decade, my margin of safety tries to answer two questions "do I have enough to bridge the gap without working" and "what are the odds of the pension not being paid". Thus I'm not exactly in the position as most striving for ERE.
However, coincidently, I was just doing some modeling on my portfolio two nights ago as to how much should be high yield fixed income vs. municipal bond funds vs. dividend growth stocks.
The goal was to optimize after-tax yield and yet maintain a reasonable growth rate. As the after-tax yield went up, the growth rate went down. I want at least 4% annual growth (to beat typical inflation) with an after-tax yield of not less than 4%.
So, while I'm still working, the best yield meeting the minimum growth rate translates into 65% dividend growth, 25% high yield, and 10% tax free. At the other end of the spectrum, the maximum growth rate which met the minimum yield was 90% dividend growth and 10% high yield. What surprised me was that tax free was not as important as I expected. The difference in growth and after-tax yield is only about 25-30% regardless of how the variables are mixed.
Next up is to run the gamut with anticipated post retirement numbers to see how the mix should change.
Note that the numbers I'm using for pretax yield in the various segments are for my portfolio and investment style. They might not be the same for you.
I approach the margin of safety differently. First, I plan using a 3% SWR. Second, my post-retirement budget is not based on the absolute-minimum-to-survive level of expenditure. It has some padding whilst remaining fairly frugal. Perhaps the biggest variance is in food costs. I eat quasi-paleo and I like to cook; but if I had to I could live primarily on white rice, beans, eggs, and loss-leader seasonal produce.
I do plan to RE the very month when my monthly budget is supported by 400x (i.e. the 3% SWR). If we have a bad year like 2008-09, then I will decrease my spending to the "survival" level (tested twice for a three-month period) to ride it out.
Part of me looks forward to the challenge of meeting the occasional financial strain. It's analogous to getting a little dirty to develop antibodies versus constantly using hand sanitizer to kill every germ. I want to remain resilient and adaptable throughout my life. This draws upon the social and intellectual capital that @Jacob remarks upon in this blog post of his: http://earlyretirementextreme.com/angry-people-online-insults-frugal-lifestyles-and-the-poor.html
I know that some of my activities after retirement will yield me some money, and also know that wife will want to make and stock some money of her own by selling some produces like handmade things. I also have no fear of making some money via freelance jobs sometimes (like fixing things, electricity jobs, maybe some carpentry). I also plan on keeping lowering expenses, by avoiding electricity (using solar power as much as possible), having my own water well, growing some of my food, having some chickens. Eventually also selling some surplus.
I could also teach some things that I know for money, like computer skills or brazilian jiu jitsu. For example, a friend of mine that also is a purple belt got a position where he gets one month minimum wage for teaching 4 classes of bjj a week for children. Each class is 1h30 long (minimum wages in brazil are measured by month and not by hour). In my current spending level, I could live of that if I need to.
Because of that, my preparation for retirement is more of a question of improving skills than having a lot of money. My safety margin also does not rely so much on money. I take a quite optimistic approach to what the return of my investments will be. In the current situation of Brazil, government pays me 6.6% above inflation for buying his debt (I think this is what you call bonds, isn't it?). This has been the case for some years already, and maybe it will last some more. After taxes I can easily count on 5% above inflation. Brazil has one of the highest interest rates in the world. I also plan on having some of money in CD's (quite high returns here) and stocks, maybe some gold. I like the PP concept.
I know that I should not expect these easy high returns to last forever, but because I also will make some money through some activities that I will do anyway, it is quite safe to assume 5% yearly above inflation. MMM even assumes 7%.
I also plan on buying some land, then I will make enough money to pay for my monthly expenses considering 5% swr, then stock money until I buy the land, then maybe some six months or one year getting used to the situation of depending on investments. Then goodbye. By that time I will have around 20 years of living expenses. If only I protect it from inflation, I don't even need investments and yet will be able to live without much work for 20 years. The other good thing is that after ERE I plan on reducing my expenses by around half of what they are now, by becoming a little more self-sufficient. That in theory would make that net worth enough to last maybe 40 years if only I protect it from inflation. That means, 0% of returns above inflation. I'm 30 now. That's such a crazy safety margin. I could even forget about 5% yearly swr. But the thing is, my safety margin is more in my hability to produce than in the money itself. And I'm not even thinking about social security, family help...
If finding and buying the land (probably together with a friend or more than one) doesn't take too long I may well be able to retire after three years of discovering ERE (having not much of a net worth before that).
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