You’ve made all the sacrifices that need to be made.
You’re saving a huge proportion of your income.
Your living expenses have reduced substantially and your investments continue to grow.
Your net wealth grows at a rate that defies your expectations. The point where your investments generate more income than you can save from working.
You’ve been following the formula for years now.
When your friends were out buying new cars, you made do with what you had and rode your bike to work instead.
While your friends and family bought bigger houses, you optimised your life to reduce costs and boost savings.
You worked hard to grow your income, but you saved even harder.
All those days spent tracking what you spend and the return on your investments has led to this moment.
You start to wonder…Can I retire?
At some stage, you will reach the tipping point when you can afford to live the life you want. The day when everyday is a Sunday.
The day when you don’t have to go to work anymore, and can start living off your investment income instead.
Ultimately, when your investment income covers your living expenses, you’re ready to retire.
If you can do that, you never have to worry about money again.
The 4% rule
Over time I’ve learnt a valuable lesson - your ability to retire early is affected more by your spending level than your income.
To retire early, all you need to do is earn more income from investments than you spend on expenses.
The lower your expenses, the less assets you need to fund your lifestyle.
To retire earlier, just keep reducing your expenses.
When working out how much I need to retire (or more specifically, how much your investments will earn), I like to use the 4% rule.
Most good investments will average 8% return per year, comprised of 4% income (think dividend income or rental income) and 4% capital growth.
By multiplying your invested capital (your investment value) by 4%, you can quickly work out how much income you can expect to earn each year.
Utilising the 4% rule, the table below provides an example of how much you would need invested to fund your living annual living expenses.
Living Expenses p.a. | Capital Invested earning 4% p.a. |
$24,000 | $600,000 |
$50,000 | $1,250,000 |
$100,000 | $2,500,000 |
$200,000 | $5,000,000 |
As seen above, there are some pretty obvious benefits in keeping your expenses low.
If you can get your living expenses under 4% of your income, you’re ready to retire from the rat race.
Even better is in theory, you would never need to draw down on your capital. Ahh, financial bliss.
An example of how this would work is as follows:
Joe Bloggs started reading about early retirement and investing at a young age. As a result, he was able to achieve millionaire status at the age of 40. He has $1million invested in assets, producing a 4% return, for $40,000 a year in income. Joe wants to retire so he keeps his living expenses to under $40,000 a year. As he is living off his investment income, he doesn’t need to sell his investments to fund his lifestyle. Therefore, over the long-term, his net worth continues to increase, as his investments continue to increase in value. He can continue doing this indefinitely.
Why is it best not to draw down on capital?
The 4% rule is something that I didn’t even realise was a popular concept until I started reading personal finance blogs.
I just assumed that in order to retire early or be financially independent, I would want to live off my investment income without ever drawing down capital.
Knowing that you can live off investment income and fund your lifestyle without having to drawdown on your capital sounds like the ultimate peace of mind for me.
I assumed everyone else would feel the same.
How wrong I was.
Of course you can draw down on your capital during retirement, after all that's what most people do. But it really is a slippery slope as every year you draw down on your invested capital, you reduce your investment earnings each year.
Besides, what’s the point of retiring early and depleting your capital early?
That certainly doesn’t sound like a great long-term plan and you’re certainly not going to want to go back to work once you are in your twilight years.
When you reduce your capital along the way, you are reducing your annual returns and therefore increasing the risk of running out of money.
Let’s assume Joe needed to fund a $100,000 p.a. lifestyle. He still wants to retire at 40, but is happy to drawdown on capital as required. Let’s see how this plays out for Joe, assuming a 4% investment income and 4% capital growth per year.
Age | Capital | Income | Drawings | Balance |
Age 40 | $1,000,000 | $40,000 | $100,000 | $980,000 |
Age 41 | $980,000 | $39,200 | $100,000 | $919,200 |
Age 42 | $919,200 | $36,768 | $100,000 | $855,968 |
Age 43 | $855,968 | $34,238 | $100,000 | $790,206 |
Age 44 | $790,206 | $31,608 | $100,000 | $721,814 |
Age 45 | $721,814 | $28,872 | $100,000 | $650,686 |
Age 46 | $650,686 | $26,027 | $100,000 | $576,713 |
Age 47 | $576,713 | $23,068 | $100,000 | $499,781 |
Age 48 | $499,781 | $19,991 | $100,000 | $419,772 |
Age 49 | $419,772 | $16,790 | $100,000 | $336,562 |
Age 50 | $336,562 | $13,462 | $100,000 | $250,024 |
Age 51 | $250,024 | $10,000 | $100,000 | $160,024 |
Age 52 | $160,024 | $6,400 | $100,000 | $66,424 |
Age 53 | $66,424 | $2,656 | Uh oh | $0 |
As you can see, Joe completely depletes his assets by the time he is just 53. He will either need to back to work and may end up on the age pension in his retirement years, neither of which sound particularly appealing to me.
Not reducing your capital is particularly relevant for early retirees, as your money needs to last a lot longer than is the case for those retiring at 65 years of age. In addition, you may not be eligible for government pensions when you retire early.
If your goal is to retire early, you want to be living off just your investment income, because you can do this indefinitely.
Why reducing your expenses makes it easier to retire early
When it comes to retiring early, reducing your expenses has several benefits:
By reducing your expenses, you can accelerate your wealth creation. Instead of purchasing all those unnecessary things that don’t actually add value to your life, you could be buying assets that will make you money instead. As you become more accustomed to controlling expenses and living a less expensive lifestyle, these habits will continue in your retirement years.
The lower your expenses, the less invested capital you need to retire. This means you can retire much earlier than someone living a typical and costly life.
When your lifestyle expenses are low, you need less investment income to cover your expenses. This works in your favour as if you are able to survive off less investment income, you will also pay less tax on this income as well. This helps your money go further in retirement.
“When can I retire?” is one of the most commonly asked questions I received.
You reach the crossover point when your living expenses can be completely funded by your investment income.
Of course, there are ways you can get to early retirement even faster:
Supplementing your investment income by doing some part-time work in retirement. This can be particularly useful to cover unexpected expenses or if you are approaching the need to drawdown on capital.
Funding your lifestyle until you are eligible for a Government pension. It’s not a particularly graceful strategy, but it does make early retirement more achievable, as you only need to fund the unsupported period.
For me personally, the goal isn’t to retire just yet. It’s to have enough capital invested to live the life of my choice. Financial freedom is the goal.
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