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Retire Early: How Much Do You Need?

July 21, 2017


How did you go with that calculator from last week’s article?

Hopefully it helped you see how your savings rate is the magic ingredient to financial independence.

Bumping up your savings percentage can pull forward your freedom date by a huge amount!

So, how much do you actually need to retire early?

It’s a common question. In fact, it’s probably the most asked question of all, in the early retirement space. In truth, the answer is different for everyone.

It depends largely on how much you want to live on, and how much income your investments generate.

Many people will need a crap-load of money to retire early.  Others will only need very little.

And it’s not hard to see why.  Obviously, the $200k per year spenders need way more money in investments to retire, than the $40k spenders.

 

Think Differently

One of the best ways to think about this question, is by changing it completely!

Instead of thinking… how much do I need?  I learnt to think… how little do I need?

Maybe that sounds like a silly play on words, but it made a huge change in our decision-making.

Originally, I thought we would need quite a lot to retire.  In my head, I thought to retire you need to be rich.

And if you’re rich, you live large.  Therefore, you would need lots of assets to retire on.  You had to be in the multi-millionaire club.  At least, that was my assumption.

The truth is, to be financially independent, you don’t need to be very rich at all.  To quit your job and live freely requires only a fraction of what I thought.

Yes, you need to save and invest a good chunk of money. And do this for a good chunk of time. But as long as those investments are providing you a strong income, the amount doesn’t need to be huge.

After I started thinking “how little do I need?”, we started to realise we could live very happily on much less.  This allowed us to get our life back way, way sooner than we thought.

 

Think about it this way…

Basically, you can set out to achieve any level of investment income you want.  But that will require you to be at work longer to achieve it.

In the end, what we are really doing is deciding whether we want more money… or more time.

There comes a point for everyone, where the extra money is not worth the time they are giving up.  It’s your life after all.

When we realised how little we needed to be happy and live on comfortably, our thinking changed rapidly. We definitely wanted our free-time back, more than anything else.

I share this in much more detail in my podcast with Aussie Firebug, which you can find on this page.

So with that in mind, let’s crunch some numbers…

 

Retire On Dividends

Let’s say you go about building a solid portfolio of diversified Aussie LICs (Listed Investment Companies).  Find out more about different LICs and why I like them here.

The long term average for dividend yields in Australia, is around 4%.  When we include franking credits, this becomes 5.7%, giving our income a huge boost, as I discussed in this article.

This tax system may change in the future of course, so if you want to be conservative, go ahead and just use 4%.  Anyway, this dividend machine will spit out cashflow for you to live on each year.

Importantly, we can expect this income to increase over time too, as companies earn more and increase their dividends to shareholders.

Here’s some simplified before-tax examples of the gross annual dividend income it’s possible to generate…

$2m portfolio would provide $80k of dividends ($114k with franking).
$1m portfolio would provide $40k of dividends ($57k with franking).
$800k portfolio would provide $32k of dividends ($46k with franking).
$600k portfolio would provide $24k of dividends ($34k with franking).

So far so good.  Where it gets interesting is, when you use these figures in combination with the thinking I outlined above…

 

How Little Do I Need to Retire

If you decide you only need an income of $40k, instead of $60k, you can quit your job much earlier.  You just pocketed a few years of your life back, and likely saved yourself a couple hundred grand!

Maybe you’d be happy working part-time or having a house-mate.  Or getting away from the noise and traffic of the city.

It wouldn’t be too hard to use a couple of these strategies in combination with a smaller portfolio to retire much, much earlier.  Make no mistake, the FIRE journey is not about sacrifice.

 

What about this…

Let’s say you have $50k of expenses living near the city.  Moving further out, with lower-cost housing, this may reduce your expenses to $40k.

If you haven’t heard, your lovely house could be costing you your freedom.

If you’re happy to work part-time, you might earn $20k of income.  This means you only actually need $20k of investment income, to have your bills covered.

To generate $20k of dividend income, you would need around $350k of savings.  This means you could actually semi-retire at that point with only $350k!

It’s worth thinking about these options, and how you can get your life back sooner.  Maybe you won’t change a thing, but it’s better to make an informed choice, instead of thinking there was no other way.

 

Shares for income.  Cash as a buffer.

By now I hope it’s clear from my writings, that dividends can be an excellent income stream to retire on. This doesn’t mean they’re bulletproof.  Far from it.

Our money invested in index funds or LICs is spread across huge swathe of different businesses.  And business profits are lumpy.  Some years they make a lot of money, other years less.  So it should be obvious, dividends can fluctuate too.

LICs are really just a listed managed fund.  It’s their job to manage our funds, by investing across a broad range of shares in different businesses.

While some companies are doing good, others may not be.  The average is what matters.  Overall, the portfolio of shares inside the LIC should deliver a relatively stable and increasing level of dividend income, which is then passed onto us.

Although, if we hit a recession and many companies reduce their dividends, the LIC will receive less dividends and may have to reduce the dividends they pass on to us.

This is why it’s important to have a cash buffer.  By having a couple of years living expenses in cash as a buffer, we can ride out the storms, by topping up our income in the years where dividends are reduced.

Related post:  What If Australia Crashes?

So in addition to our Aussie share portfolio, we should hold perhaps 2-3 years living expenses in cash.

A rough rule of thumb to use is this… with Australian shares you may currently need roughly 20-25 times your annual spending to retire.

Here’s my investment philosophy in full:  Should You Invest For Income Or Growth?

 

How does it work in practice?

Well, every year you continually save money and buy shares, your passive income from dividends goes up.  And every time you receive a dividend and you reinvest that money, your future income goes up.  And every time your investment increases the dividend paid to you, your future income goes up.

This is what I call, the Relentless Progress of a Dividend Investor.

Perhaps we want to live on $50k per year.  We’d currently need around a million dollars to retire. (20 times annual spending)

Using the dividend figures above, $900k in shares will provide just over $50k in gross dividend income.  And $100k is kept in cash as a backup.

Essentially, the less flexible you are in your spending, the more cash you should keep on hand.  If you are unwilling to reduce spending for a little while, you may need a bigger buffer.  And those who are more flexible, may need less.

Having cash on hand is perhaps the best backup plan there is.  Other people may prefer to rent out a room in their house, spend less, or do some part-time work until dividends recover.  We’ll cover backup plans in a future article.

In summary, I think a 2 year buffer is the most realistic and sensible buffer.  And all up, when we combine the cash buffer with our LICs, we need around 20 times our annual spending saved.

To reiterate the ‘living off dividends’ approach – this means, an Aussie index fund or quality LICs (or both) providing a strong level of income, covering our expenses, and also, a cash buffer of roughly a few years of living expenses to cover for any serious reduction in dividends.

 

Increase Your Savings By 20X!

We’ve talked a lot about saving here on this blog so far.  And that’s because I’m lazy!

Not lazy because I can’t think of anything else to say.  But lazy because saving is the easiest money you can make.  I hinted at it before, but let me explain…

Let’s say we’ve got a household who spends $60k per year.  Perhaps they read an article about treating their finances like a business.

Then, they read my article of how we retired in less than 10 years, by building up our investments and cash to 20 times our annual spending.

After this, they decided to optimise their spending and live on $50k per year instead.  It’s only 10k per year difference, which doesn’t sound like a lot.  But in reality they are better off by $200,000!

How?

Well, their $60k annual spending required a net worth $1.2m to sustain them.  But with their new $50k spending, now they only need $1m.  Hence, they are now $200k closer to financial independence!

If they can only manage to shave their expenses down by $5k, they still move their target closer by $100k!

Basically, this means any reduction in annual spending has a 20x benefit!

Make no mistake, there is a direct link between desired spending and retirement.  Folks can happily work for decades building their equity well into the millions, to pay for the lifestyle they apparently need.

That’s fine, but it’s not for me.  And if I had to guess, I’d say there’s plenty of people out there who would rather just get their life back first.

One of the most important lessons I’ve learned over the last 10 years is, it doesn’t take a lot of money to retire early and live a great life.

 

Choose Your Future

The whole reason I’m retired right now, is because I stopped thinking about how much we needed to retire.  Instead, I started figuring out how little we needed to retire.

I believe in reaching financial independence as soon as possible.  And doing it on as little as possible.  After this, your whole future will be whatever you want it to be.

To me, this is true financial strength.

You have your expenses covered by investment income.  Now you’re in control.  And you now get a choice over everything.

You can stay in your job if you want to, not because you have to.  Maybe you’ll volunteer, work part-time, start a business, or just enjoy your family and your hobbies.

Whatever it is, your mindset will be completely different.  Here’s a look at our simple and happy life after reaching financial independence.

You’ll be in a position of strength and freedom, knowing that none of it is because you have to!  You can still earn extra money to pay for a bigger house, newer cars, or more holidays, if you want to.

After we made the connection between our desired retirement income, and how many extra years we had to work to get it, we realised that it just wasn’t worth sacrificing so much of our life for.

The ability to retire early and have our freedom was far more important.

After all, we could always go back to work to make extra money for those things anyway… if we want to.

10 Comments

10 Replies to “Retire Early: How Much Do You Need?”

  1. Great post! Every article seems to be about how everyone won’t have enough to retire. My grandparents are a good example of those who were around well before mandatory super became a thing, and while they live off the pension they are some of the most content people I know. Always happy and friendly and have so much time for others. They live simply but are very happy. They definitely inspire me to live more simply (and therefore need less money!)

    1. Thanks for sharing your story! Agree, too many negative articles suggesting people need $1m minimum just for the basics lol. It kind of works the opposite to how you’d expect… the more simply you live, the more you realise you only need very little to live a good life. I looked at the pension numbers a while ago, they’re actually not bad!

  2. Woah! This article really got me thinking. Not about reducing expenses – we’re trying to drop those by 10% this year (they will still be way too high, I think it will be a multi-year experiment). I know I want to drop a day’s work in about 2 years time. That’s something I value. What I’d never considered is that the more we save and invest, returns might actually cover that lost income. Seriously, *mind blown*. I’d be more than happy to keep working part-time for longer so I can get my time back now.

    Thanks for this article, it’s put a spring in my step and given me a different way to look at moving forward into our future.

    1. That’s great! The whole point is about being flexible in thinking and it doesn’t have to be all or nothing, you can make it suit your own situation. Most people would prob just prefer the part-time semi-retired situation. Some investments to pay bills and some work to cover the rest. More time, more freedom, less stress but not bored.

      Made my day knowing this article made you feel better about your future 🙂

  3. Fully franked dividends really are awesome… if you could make that $48k in dividend income fully franked, then at tax time get a nice refund from the ATO due to the delta between your effective tax rate and the company tax rate.

    1. Absolutely. I always include the franking credits in my calculations and use ‘grossed up’ yield. It’s real cash after all!

  4. Great article.

    I wanted to ask you about the cash buffer idea. Do you mean a true “cash” buffer, as in having $100k in a bank account to cover expenses for 2 years?

    Wouldn’t it be better to have that $100k invested in your LICs and then simply reinvest the excess dividends of approximately $5,700 each year? This way your investment portfolio would be continually growing at a rate most likely to be much better than having $100k in the bank. If a market crash came and your dividends were reduced, you could sell some of the LIC shares at that time to cover your expenses. You would then be left with fewer shares of course but as those shares were excess to your needs anyway, you would be no worse off with regards to the income necessary to fund your retirement.

    1. Thanks PKFFW.

      Yes, I meant real cash in a savings account earning a piddly 2-3%. You’re right that it’d earn a higher return in shares, but that’s missing the point I think.

      The buffer is there in case of a true market crash and economic downturn, where dividends may be reduced anywhere from 20-40%, and prices would be down 40-60%. Your cash buffer would be able to top-up your dividend income for quite a few years while dividends recover. There’s also the case for being personally flexible and spending less in that situation. Having to sell at this time means selling a large number of shares at low (crap) prices – not ideal at all.

      Most of all this helps the retiree focus on the income flow which is much more stable than prices, and their cash savings, without a need to look at prices and make sell decisions.

      Your approach might work, but it really depends on the level of the downturn. If it’s a big one, prices will be down dramatically and the portfolio can be quickly eaten away by selling at low prices. That’s really the worst case scenario. But I think overall, a cash buffer is safer than the sell-down approach, portfolio wise and emotionally too.

      That’s the conclusion I’ve come to, but others may see it differently.

      1. You make a good point I had not considered. I agree with your point about having to sell into a big market crash not being optimal. A true cash buffer would be the safer option in that regard.

        Of course the problem with having a large cash reserve is that who knows when that market crash may come? You could have your cash wasting away for many years, losing value in real terms, before a crash comes.

        I guess which is the “better” option would, as always, depend on the individual’s risk tolerance and how they were structuring their retirement asset base and income stream.

        1. Well the main thing is the cash buffer is in addition to your dividend-focused portfolio which will be growing over the years. You can simply reinvest the interest 2-3k per year, for it to keep up with inflation.

          The aim of this extra cash is as a safety cushion, not to earn high returns. It’s not ideal, but it’s a great backup plan. The main thing is it’s there, as peace of mind, even if for some reason the market didn’t crash for 30 years.

          As a general rule, the more flexible people are, the less cash buffer they need. If they’re willing to do some part-time work in that scenario or rent out a room in their house, spend less etc. they may need less cash. But given it’s 6 months between dividends, there’s always a certain amount of cash that is necessary to keep sitting around.

          Also if the dividend flow from the portfolio is far higher than someone’s expenses, then they have less of a need for the cash buffer too. This is just my general guideline that can be tailed to suit the individual.

          Cheers!

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