Tobold's Blog
Tuesday, July 06, 2021
The complicated math of retirement

98.375% of all investment advice on the internet is as fake as my 98.375% number. The subjects most people are interested in are sex and money, and many social media platforms have severe limitations on what sex content you can offer; so there is a plethora of content about money, just because it attracts a lot of eyeballs. The content includes a lot of scams, investment advice designed to pump & dump a specific stock, fake millionaires, and some popular influencers who don't realize how lucky they are, and how real life is for the rest of us.

If you look up financial advice on retirement, you inevitably stumble upon the FIRE (Financial Independence, Retire Early) movement. The idea is based on some easy looking math: Imagine at the age of 20 you earn $125,000 per year. You save 80% of that, $100,000, and spend only $25,000 per year. 10 years later, you have $1 million on the bank. You retire at 30, and as long as your investment yields at least 2.5%, you can keep up your current lifestyle forever. (If you assume 3% or 4% yield, the numbers change a bit, but the principle stays the same.)

While a 3% yield from a balanced passive investment budget isn't unreasonable, the flaw of the scheme lies in the other assumptions: The overwhelming majority of people don't earn $125,000 per year at the age of 20. And living on $25,000 per year is extremely frugal, and is only possible in specific circumstances, e.g. married with no children, with your partner on the same scheme contributing another $25,000. The annual median household income in the USA is under $70,000, and for people at age 20 it is below $50,000. And the required savings rate for the FIRE scheme doesn't scale down well: If you earn $50,000 at age 20, living on $10,000 per year is nearly impossible, you'll spend that much for rent alone in most places. And if you are single, and have children, you'd be hard pressed to save anything at all.

But while retiring at 30 will only be possible for a very select small group of people in very lucky circumstances, the "3% rule" on which the scheme is based isn't wrong. You can count whatever savings you have, and assuming a reasonable and low-risk broad investment strategy, assume that your income from your savings is about 3% of that. At least historically speaking that is true, but of course "low risk" isn't the same as "no risk". If right after your retirement starts there is a major financial crisis, and you lose 30%+ of your savings, your calculation goes out of the window. And inflation can also mess up your numbers, depending on how inflation-proof your investment is.

The other fundamental truth of the FIRE scheme is that how long your money lasts depends very much on how frugal or luxurious you live. If your dream of retirement is having a small house in the countryside and spending your time gardening, that is more easily realized than a retirement mostly spent on a cruise ship. Even without luxury, your cost of living might be much more than 20% of your income. One reason why retirement at 60 is more likely than retirement at 30 is that many people have children, and at 60 those children are hopefully grown up, out of the house, and financially independent. And with full retirement age in most places being 65 or more, many people still consider retiring at 60 as "early retirement".

The math of that is complicated by a lot of factors: On the positive side, if you retire at 60, you probably benefit from some sort of state pension scheme, like social security in the USA, with an average monthly benefit of $1,382. You probably also get something from the companies you worked for, either as a monthly pension, or as a lump sum on retirement adding your savings. That is very important, because the average retirement savings in the USA are only $65,000. In other words, a lot of people live mostly or purely of their social security or other monthly pensions, not their savings. 3% of $65,000 is only $2,000 per year. But in the USA, the money is very unevenly distributed, and there are 13.6 million US households with a net worth of $1 million or more. If you are on the richer side of the spectrum, have $2,500 of monthly pension benefits (combined social security and private pension), and you have $1 million on the bank, you end up with an annual income of $60,000. On the other hand, we don't have numbers on how many frugal millionaires there are, and $60,000 per year doesn't exactly give you a "millionaire lifestyle". If you get your math wrong, you might be a millionaire at retirement, and broke a decade later.

Where it gets complicated is that in the calculations up to now, we calculated your income for the case that you will live forever. That is unlikely. If you retire at 60 and you would know for certain that you will die at 80, you could take out 6.5% of your savings every year while having only a 3% of investment yield; your savings would get smaller over time, but there are formulas that would allow you to calculate how much you can take out so that the money runs out after exactly 20 years. The obvious problem is that you don't know how old you will get, some people die before they are 65, others live to 95+. You also don't know how your health will develop. A nursing home can cost over $100,000 per year, and that doesn't include medical cost.

So how do you determine whether you can afford to retire? Probably the safest bet is to find out what your monthly benefits from your various pensions scheme are, multiply by 12 months, and add 3% of your current savings (plus lump sum pensions) to that. That gives you the "forever" annual income. If you can live with that, you can probably afford to retire. To some extent, counting only on 3% of your savings as income from it balances out the risk of additional expenses for care at end of life. But of course there are no guarantees in life. But the "3% rule" of the FIRE movement explains why 57% of Americans retire before reaching full retirement age. The more you save, and the more frugal your lifestyle is, the earlier you can retire. But retirement at 60 remains far more likely than retirement at 30.

I keep the 2012 post by Mr Money Mustache bookmarked and occasionally re-read it for motivation. It breaks it all down into "shockingly simple math," e.g. if you can save 50% of your income (and live off the other 50%), you can retire in 17 years. Turn it down to 30% and you're stuck with 28 years, or turn it up to 65% and done in 10.5 years.

In practice, as you mentioned, things are less simple. Kid in daycare? That's about 15% of our household income, not counting literally anything else (diapers, clothes, toys, food, etc). It took me 15 years to pay off my student loans, which was for a degree that has had zero material impact on my career. My wife's pets are getting older, and we ended up spending about $700 in a week on vet bills for tests and treatment. And so on and so forth. It would be worlds easier for those tech bros living with six roommates in San Francisco getting $150k for a few years and socking it all away.

Having said that... the math behind everything does make me feel better about life in general. You look on news sites and there's articles about how you need $2 million to retire comfortably, which is basically impossible - the average US worker earns $1.7 million over a 40-year career. When I look at my Excel sheet, I see that my monthly maintenance expenses are around $18k/year. That's like $450k. Now, we'd need some padding to that to cover long-term purchases/repairs and spending money, but it's all so much more attainable.

Then again, I'm in the US. So even if the stars aligned and I somehow retired early, I'd have to worry about healthcare for decades, and having that eat into cash pile.
Well, another solution is to just have a job that you like doing.... you don't feel the need to retire early and even after retirement you can get a contract to continue (even with reduced salary) to keep yourself occupied. Your experience can also benefit any newcomer joining the workplace.
Of course there are horrible jobs that you'll want to flee as fast as you can, but with rare exceptions, they are also the kind of jobs which will not pay enough to allow you to retire early.... which make all this kind of math useless.
Like Azuriel, I use it mostly for inspiration. I'm in my early 30s, and I do expect to be fully retired by 40 (or at the most, doing 3-5hrs a week of maintenance work for my business). However, I agree that for most people this isn't practical. This only became a goal for us once my business started taking off, catapulting us into the top 1% of income earners.

Even when we were in the top 10%, we weren't considering nearly such an aggressive timetable, as we like to spend money, and don't hate working. It's only after we became exceptionally fortunate that we realized we just don't require such a substantial income long-term, and it made sense to transition to saving most of it, in order to prioritize travel and other fun activities.
"Then again, I'm in the US. So even if the stars aligned and I somehow retired early, I'd have to worry about healthcare for decades, and having that eat into cash pile."

Have you considered retiring outside of the US? My wife and I have talked about retiring in her home country of Panama. It's more affordable then staying here in the states.

To be honest, I'm not quite sure what the world is going to look like in 30 years (2050) vis-a-vis the climate. I cannot imagine that things are going to be good for those closer to the equator, even if I were not concerned about kidnapping and violence towards the rich. Maybe Panama is fine, but still, I don't particularly want to be anywhere near a coastline. Already I try to talk people out of moving to Florida, but maybe they are better at musical chairs than I am.

I recognize the cognitive dissonance with the "retire early, everything fine" and the "we're kinda fucked" sentiment, but what else can you do other than hope the ship turns itself around?
Not sure whether that is cognitive dissonance. I mean, if you knew the world would end tomorrow, would you go to your office and try to get that spreadsheet done? Most people work to live, not live to work.

My current job actually involves fighting against climate change, by doing research. My honest opinion, as a scientist, is that we will not be able to limit global warming to under 2°C. That isn't to say that what we are doing is useless, and the more we do, the less we will overshoot. But seriously, don't buy a house near the coast.

I'm on board with moving after retirement. I myself plan to move from the city to a smaller town. The main attraction of the place I live in now is that it has a reasonably short commute, and is close to a major train station and airport for business travel. Not going to need that anymore! There is a global trend of people moving into cities, so rent and property is more expensive there. Moving in the opposite direction can lower your cost of living. Moving abroad is an option, but you need to consider a lot of factors, like living standards and language.

The dissonance comes from the fact that retiring early is predicated on 4% post-inflation returns for 30+ years. If the global economic system collapses due to war, climate migration, water scarcity, etc. etc. etc, then you kinda scrimped and saved for no reason. That's especially true if your wealth is tied up into stocks, which is pretty much the only reasonable way of retiring early for the average person.

On the other hand, that's not a particularly optimal way of living your life either. No one is coming to work on the day the world ends. But what if it ends... 5 years from now? Or 20? Or 100? Or X, where X could be anything? I'm not optimistic on an intellectual level about the near-term fate of humanity (especially after the last four years), but I still go through the motions of assuming the world and global economy will be around long enough for my actions to make sense. What else can you do?
@ Azuriel

This mentality has never made sense to me. It seems the height of hubris to assume that we're anywhere near the end of the world. As bad as Trump's America was, it wasn't Nazi Germany, and even if it was - the rest of the world do move on without it, especially with increased globalization.

Climate change is slightly more of a concern, but only marginally. It is exceptionally difficult to imagine that even with increased severe weather, sea level changes, etc, there would be such global devastation to the major economic centers that it would impact one's ability (as a citizen of a first world country) to live a fulfilling life. Certainly not within the lifespan of anyone old enough to be commenting on a blog.

Don't get me wrong, no climate denier, me. But the hyper doom-and-gloom of the left (especially the American left) is almost as out of touch as the right.
For some reason there seems to be more right-wing spam around than usual. According to my spam folder, we are at the end of history, as Biden is going to turn the USA into a socialist system. So, you can forget about early retirement. :)

While I personally am worried about the state of democracy in the USA, I would like to point out that a lot of countries are less democratic than the USA, and their world hasn't ended. History is often best understood as swinging pendulums, and American tyranny would probably be followed by a second American revolution. The current attack on democracy is trying to entrench minority rule, and that historically tends to not work very long, once people got a taste for democracy. Not saying it is going to be pretty, though.
I never get political spam from either side. It's mainly African princes, e-mail marketers, random offers to buy technology in bulk, and medical stuff.

If Republicans had control of the House of Representatives seven months ago, it is entirely possible that the election results would have been thrown out and Trump would be serving another term. Any challenges to that would be argued in front of a Supreme Court that had three Trump appointees and otherwise has a 6-3 majority. Once you steal an election in broad daylight like that, it emboldens you to do more while you still can. Hell, Republicans lost and yet there are dozens and dozens of laws getting passed right now in various States making it more difficult to vote in the next election. If Republicans win in 2022, guess what happens in 2024 when the presidential election results need certified? The playbook has already been rehearsed.

Meanwhile, on the left, do you imagine the protests/riots/attacks would be LESS intense than the ones for George Floyd had the results been de-certified? Something something four boxes.

Will the US or the world instantly collapse into a wasteland? No. But this sort of blithe "things will work themselves out" hand-waving is especially ridiculous coming out of what we all experienced in the last year. Last summer, my infant had a high fever and I was trying to buy some medicine and everything was... just closed. No pharmacies were open past 7pm. None. First-world country and shit was just shut down everywhere. No one cares much about the climate until the power goes out and stays out for week. And as for moving elsewhere, how 'bout them house prices? Think it's going to be better or worse over time when the aquifers dry up and everyone gets the same idea that summer temps in the 110s is not that fun with kids?

Humanity will probably survive - we get used to all sorts of things. But if you're asking if I believe on an intellectual level that the stock market is going to return 4%+/year for the next 30 years like it has up to this point... then no, no I don't think it will. But I also don't want to live in a world where ammunition would be a better investment either, so... ¯\_(ツ)_/¯
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