How to retire early

Allow me to start by asking these two questions. They represent the extreme ends of the scale, but take a moment to think about them.

1. If you spend 100% of your income and save nothing, at what age would you be able to retire?
2. If you spend 0% of your income and save everything, at what age would you be able to retire?

Taken a moment to think about these two extreme situations? Good. Lets discuss.

In the first scenario of spending 100% of your income and saving nothing the answer is quite simply you can never retire. Now before you stop me and say "what about government pension payments" remember you have come here seeking advice on how to retire early, not retire when the government says you can retire which is getting pushed back every year as we live longer and longer. Putting government pension payments to one side for the moment, I'm sure we can both agree that if you save nothing you will never be able to retire. Now, lets examine the second question I asked.

The answer to it may not be as intuitive as the first but is surprisingly obvious once it is pointed out. If you spend 0% and save everything you earn you can drop everything and retire RIGHT NOW! As I touched on earlier, this is at the extreme end of the scale and spending 0% isn't possible in the modern world unless you live on the street picking half eaten hamburgers out of the trash. Obviously, we need to find a balance between spending 100% and spending 0%. What is the balance? Well, it will change depending on your situation and what your goals are. Lets continue the discussion and hopefully by the end you will be able to see the big picture and be excited to begin planning your early retirement.

Every dollar that you save and invest becomes a worker making more dollars. The best thing about these workers are that they never take a break. They keep working 24/7 and before you know it the results snowball thanks to a mathematical marvel known as compounding.

We have all learned about compound interest in school, but very few of us take advantage of it and some are actually the victim of it when they run up large unpayable credit card debts or take out ginormous home loans. By contributing to our savings early we can make the power of compounding work for us rather than against us when we take out loans for things we can't afford, which has the side effect of making us debt slaves.

Now, the secret to early retirement actually requires a strategic operation on two battle fronts. The first, as I have touched on above, is save save save! Save your dollars and get those workers producing more of themselves by compounding every minute, of every day of every year. The second part of the battle plan is cutting your expenses. As I alluded to in the second question I asked above, it is ultimately your level of expenditure that determines when you can retire. Since in the real world we can't survive on $0 a year, we need to combine this idea with a save save save mantra in order to retire much earlier than we otherwise could.

Lets create a hypothetical case study to examine this in closer detail. John and Jane Frugal are just starting out in life. They are 25 years old and have completed their university degrees and have a combined household income of $80,000 a year after tax. For simplicity, lets assume the Frugals exclusively invest in an indexed fund. These have low management fees, are proven to outperform managed funds in the long term, and see a long term average return of 7%. If we then assume inflation (the rate at which money loses its purchasing power over time) is 3%, that leaves us with a inflation adjusted return of 4% per year. This 4% return is going to help slash the time until you can retire AND also be the SWR (safe withdrawal rate) once you do retire meaning you could live for a thousand years and still have a nice nest egg to leave your children.

Assumptions Summary

1. After tax household income is $80,000p.a. (adjusted for inflation) for their entire working life.
2. 7% average investment return p.a.
3. 3% average inflation p.a.
4. 4% SWR (safe withdrawal rate)
5. The amount saved each year increases at the rate of inflation (in line with the inflation adjusted household income)

In our first projection, lets say they live on $50,000 a year ($1000 a week) and save $30,000. How long until they can retire? Mr and Mrs Frugal could retire in 26 years (at age 51) and continue to spend $50,000 a year FOREVER, leaving a nice nest egg for their children to inherent.

Now, as you can see they have built up a very large nest egg (2.7 million dollars), they have been living a comfortable life on $1000 a week and managed to retire at 51 years of age with enough money saved to continue to live a very comfortable lifestyle in their twilight years.

What if your living expenses were lower? How would that impact the time until you can retire or be financially independent enough to pursue your passion without worrying about paying the bills. Lets look at 3 more projections and overlay them on the graph. Just to re-iterate, these projections are using the same assumptions stated above.

1. If you only spend $35,000 p.a. then you could retire in 15 years with a nest egg of $1.35 million.
2. If you only spend $25,000 p.a. then you could retire in 10 years with a nest egg of $857,000.
3. If you only spend $15,000 p.a. then you could retire in 6 years with a nest egg of $500,000!

So, "where is all this going and how does it apply to me?" you might be asking. We can then take this hypothetical case study and go one step further. By changing the y axis from dollars to % of salary saved we can draw a graph that allows anyone, regardless of their income, to quickly project the time until they can retire based on their level of saving.

And here is the same graph again, minus the 5% return data.

As you can see, it's not rocket science. The more you save, the earlier you can retire. Everyone has different goals in life and for each person the balance of saving vs spending will be different, but as you can see it is possible to have a comfortable life and retire early. The important thing is to start saving early which can easily be achieved by making a few small changes to your life and setting realistic expectations.

I'm not the first to ponder this kind of early retirement philosophy. There are others like me who think in this way, but in this modern crazy materialistic consumerism driven world I feel like we are a minority. If I struck a chord with you, please subscribe or leave a comment below for me.