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.