Actually, none of us should complicate the principles of early retirement.
The strategy to achieve early retirement is pretty much identical to conventional retirement planning with one big exception…
It’s Time, where;
- You have less time to reach your financial goals pre-retirement
- You have more time to deplete your money post retirement
In other words, you will expect to endure a shortened, accelerated financial preparation phase, and an extended, post-retirement spending phase when you retire early.
Think of how to retire early as conventional retirement planning on steroids.
Multiple aspects of retirement planning are magnified by the compressed time-frame, and here we are going to focus exclusively on those factors affected by accelerating time.
Therefore, get a good grasp of the foundational principles of retirement planning right first.
Early Retirement Approach #1: You Need to Accumulate Faster
The usual retirement planning put the emphasis on traditional financial concepts like saving and passive investment strategies – otherwise known as the slow and secure path to wealth.
This is the perfect approach when executed judiciously over a 40 year career to finance a 30+ year retirement, but early retirees have shorter careers and longer retirements up to 50 years.
The downside with passive investment portfolios is that its annual returns are capped circa 10 – 15 percent (averaged over a full bull & bear cycle) – not nearly fast enough for those desiring early retirement at regular spending levels.
Furthermore, if you are looking at 20 years or less of active working duration, there won’t be enough time to reap the magic of compound growth of the assets.
Not having compounding interest as your ally due to the shorter time-frame of early retirement requires you to add out-of-the-box approaches to your retirement strategies:
- High level Frugality: Some people have been known to save more than 70% of their earned income to retire in 7-10 years. It’s possible, but it’s not everyone’s first preference because it could be miserable, so let’s look at two other alternatives.
- Active Portfolio Management: This is defined as adding a skill component to your investment strategies, which creates an additional return stream above and beyond passive returns. The higher investment return amplifies and accelerates the compound return.
- Apply Leverage: Leverage allows you to replace less time with more resources, thus multiplying what you can achieve in the same amount of time. Example of financial leverage: You only pay 10% of the purchase price when buying a investment property 500,000 today, while financing the other 90%. Assuming the mortgage repayments breakeven with rental income, in 5 years time your real estate property has an asking price of 800,000. After settling the outstanding mortgage, you probably have a net profit of 250,000 versus your initial capital of 50,000. Ignoring taxes and other incidental expenses, your profit is 5 times your initial capital.
2 and 3 are rare and difficult paths to early retirement that few succeed with. It requires both financial literacy, commitment and willpower – something few people choose to embark on..
Another common path to early retirement is leveraging other people’s time through business ownership.
Again, business ownership offers several forms of leverage and tax advantages not available to the passive investor. You can either follow your passion by building your own business, or you can become an owner of the company you work for through option and stock bonuses.
It’s a no brainer that these are 3 paths to wealth – paper assets, real estate, and business – but only two of these paths offer leverage (real estate and business) suitable to early retirement without extreme frugality.
The conventional retirement planning approach uses the only non-leveraged asset category – paper assets. That’s why it is the slow path.
And if you aggresive in reaching your early retirement goals, then try combining all three tools – extreme frugality, active investing, and leverage – to really put your early retirement plans into over-drive.
Early Retirement Approach #2: Negate the Inflation effect
While asset accumulation for retirement is of utmost important, you should not overlook the issue of shielding your assets from inflation.
Inflation erodes the purchasing power of your savings. You can consider it like an invisible tax on wealth that can jeopardizes your retirement security if you don’t plan appropriately. For early retirees, this is particularly more critical, because inflation has more time to do more damage when you retire early. This makes it your number one enemy.
A mere 3% inflation will cut in half the purchasing power of your money every 24 years.
In other words, you must double your money during the same time period just to break even.
If you are retiring in your 40’s with life expectancy of 90 can expect your purchasing power at 3% average inflation to get cut in half 2 times during their retirement. That’s a very big deal.
The point is this:
Nominal growth in assets deceives. The only growth that counts over the long run is increasing purchasing power. So you must be very cautious to be informed if the passive return from investing is actually growing outpacing inflation, or worst case scenario, in tandem with your personal inflation rate.
Now knowing this, you must be deeply concerned about fixed annuities and pensions that don’t adjust adequately to compensate for inflation. They are a long-term recipe for disaster. Early retirees must structure their portfolio and income sources to grow and offset inflation’s erosive effects.
Some examples that can offset inflation effect are income-producing rental real estate – which is what conventional retirement calculator cannot model!
Early Retirement Approach #3: Practice Prudent Spending
Traditional retirement planning does not take into account this fact on top of inflation:
That your spending will likely to decrease over time as you age.
Because studies show spending is proportional to activity level (emergencies and health issues aside), which decreases over time due to diminishing health and energy.
This decrease in spending with age largely offsets the impact of inflation, providing a relatively stable spending picture for traditional retirees.
However, when you have early retirement, this does not apply.
Apparently, early retirees spending pattern often increases and remains high due to an active lifestyle and greater health. Early retirees can’t rely on decreased spending near the end of life to offset inflation like traditional retirees.
This means early retirees must do at least one of the below to achieve financial security:
- Accumulate a retirement nest egg beyond what’s necessary to support current lifestyle.
- Supplement retirement income with earned income.
- Change lifestyle so that expenses decrease.
Most early retirees combine one or more of these 3 choices to make ends meet.
Early Retirement Approach #4: Create Perpetual Income Without Spending Principal
Ideally, financial planning for early retirement requires a nearly perpetual income stream that you can’t outlive.
If you are retiring in your 40’s, it is likely you have 50 years of life to support. That’s a lot of time.
To comprehend how this extended time in retirement affects spending investment principal, imagine a traditional 30 year mortgage. The early monthly payments contain very little principal, and the later payments are nearly all principal.
You can apply the same concept when it comes to living off your assets in retirement – the early payments can spend very little principal, but the later payments can spend lots of principal. This is because you will have lesser principal to generate retirement income as you progress further into the retirement stage.
The only problem is, you never get to know when the last payments will be until it’s too late.
There’s another killer:
Unlike a mortgage, your longevity is unknown in retirement. It is best to over-estimate your longevity because the alternative would mean running out of money when you need it most.
What this means is a 30 year time horizon (traditional retirement) allows very little principal to be spent, and a 40 to 50 year time horizon (early retirement) needs to be, for all intents and purposes, a perpetual income stream that can increase over time to offset inflation.
But how do you do that? Traditional retirement planning doesn’t offer a solution.
Surprisingly, the process for perpetual income planning is even simpler to figure out than traditional retirement planning, although it is harder to accomplish. The various assumptions and estimates required by all the traditional models become unnecessary complicated when planning an early retirement.
You may doubt the above statement and ask:
How can I do this safely when I can’t possibly estimate my investment returns, life expectancy, spending patterns, or inflation, with even the faintest degree of accuracy over a 40+ year future?
It would be an impossible task using the traditional models, but it’s actually rather simple to accomplish by following the 4 rules below.
(1) You must build an investment portfolio sufficient to throw off residual income in excess of personal expenses, ideally in the first half of your retirement stage. Note this doesn’t refer to total return, but only to residual income. You can only spend the income thrown off by the assets, but the assets themselves can never be touched. This distinction is critical.
When the cash flow from your portfolio is more than you spend on living expenses, then you are infinitely wealthy. No complicated math required. At this point, your life expectancy is irrelevant because you can never outlive your income, making the expected lifetime assumption irrelevant.
(2) You must manage your assets so that growth (inflation-adjusted return) is greater than the inflation rate.
For example, if your retirement income are derived fully from bond portfolio, then your growth is zero because total return and income roughly equal each other over time. This means that over the long-term, the inflation monster will likely eat your all-bond portfolio for lunch when you live off the income. Not a good thing.
Alternatively, if your cash comes from asset return that grows in tandem with inflation, such as dividends from Real Estate Investment Trust(REIT), or rental income from real estate, then you are more likely to keep your retirement principal intact.
As long as the difference between your total return and the income from your assets exceeds the rate of inflation, you can dismiss any need to estimate future inflation from your calculations. It becomes a non-issue.
(3) Your residual income stream must come from multiple, non-correlated sources. A reasonable mixture of dividend paying stocks and income producing real estate would fulfill that requirement.
(4) Consider this bonus rule as an insurance policy when life throw you a curveball.
Don’t kick start early retirement until your passive investment cash flow exceeds what you spend. Call this a margin of safety – perhaps 30 to 50 percent.
This will ensure you have money left over to reinvest.
This provides the last added measure of insurance to cover against unexpected surprises, lost income due to default, catastrophes, excess inflation, etc. Reinvesting excess revenue allows you to compound your way to recovery over time from any adverse circumstance.
It doesn’t matter how early you retire or how long you live. As long as you adhere to these 4 simple rules, perpetual financial security should be yours throughout retirement.
Money Is The Means To An Early Retirement, But It’s Not The End
Like it or not, humans are goal seeking, social, productive creatures by nature – at least, most of us are. Anyone with enough drive and brains to succeed at building an early retirement will bore quickly with full-time leisure.
When you choose the goal to retire early, it should be motivated by moving toward a new lifestyle that is more compelling than your current lifestyle.
You need a passion or activity that stimulates you. You’ll need to find an interest congruent with your values that is exciting to wake up for, and gets your creative juices flowing.
What will be the next step in your life’s journey? Some retirees blend part-time work, stint work, volunteering, the arts, launching new businesses, and any number of other occupations to add depth, human connection, and productivity to their day.
Other retirees spend more time at the gym, exercising to improve their health. Still others use the extra time to convert a previously loved hobby like flying, travel, or art, into an occupation.
None of these are mutually exclusive: you can combine them in any way that suits you. Whatever makes you happy is good enough.
There’s no right or wrong answer to a fulfilling early retirement – different strokes for different folks. You just need a compelling reason to wake up each day that is bigger than your personal self-absorption.
You’ll want to participate in the world, be creative, and remain connected. You’ll want an active social network, excellent health, interests, and the money to enjoy it all.
Don’t make the mistake of thinking money is what retirement planning should be all about. It’s much bigger than that.
Retirement planning must include life planning too, because in the end, retiring early is all about enjoying a fulfilling and complete life experience.