It’s been just over two months since I started this blog, and yet I still haven’t talked about how I’ve been planning for financial independence. For some of you, it might already be obvious – spend less, save more, invest and repeat. But how much should we be saving and where should we be investing?
How Much to Save
Let’s start with how much we should save. Imagine that during retirement, you had $500,000 in cash, uninvested. If you retired today and spent $20,000 a year on living expenses, that $500,000 will last 25 years. After that, you’ll need to find a new source of income.
Now imagine that you invested the same $500,000 and made a 4% return on it each year, or $20,000. This means that you can live off $20,000 a year into perpetuity without ever touching the original 500 grand. So if you only need $20,000 a year to be comfortable, you’ll need to save and invest a lump sum of $500,000. In other words, how much you need each year to live comfortably right now will determine how much money you should save for retirement.
But it could take a decade or two before I’m anywhere near financial independence. Are you saying that I need to commit to just $20,000 a year in 10 or 20 years? And what if I moved to a high cost of living area like New York or San Francisco? $20,000 a year would put me near the poverty line!
That’s true. So what’s a more realistic figure for you? If it’s $30,000, then you’ll need $750,000, if it’s $40,000 you’ll need $1,000,000 and so forth. The math isn’t hard, but committing yourself to a strict annual budget for the rest of your life may not seem ideal.
That’s why I like to look at my finances retroactively. For example, if my ideal level of spending on groceries is $500 a month and I spent $600 last month, then I could either limit myself to $400 this month on groceries, find a way to make an extra $100 (e.g., through Craigslist) or save $100 in some other category of expenses (e.g., eating out less or walking to work). Put another way, the key is to be flexible.
Now, let’s extend that flexibility to long term retirement planning. Looking at my expenses over the past few years, I can retroactively determine an annual ballpark figure of $40,000 that I may need to be comfortable. This means that I’ll need a lump sum of $1,000,000 to retire. But that’s based on my lifestyle today as a single, thirty-one year old guy paying a $2,259 rent for myself in New York City. Once my girlfriend and I get married and move to a cheaper location, we’ll have to readjust that figure. And if we buy property or have kids, we’ll have to readjust again. In short, the only way you’ll know when you’ve truly hit financial independence is when your investment returns have finally started to outweigh your expenses. Before that, financial independence will be impossible to predict because of our constantly evolving lifestyles. But that’s okay because it encourages us to be flexible and make adjustments along the way.
Where to Invest
Now let’s talk about investing. To guarantee a safe withdrawal rate of 4% during retirement, you’ll want to put your money somewhere that generates at least a 5% return for some added safety. Currently, I’m interested in index funds and real estate investment trusts (REITs). ETFs like VTI, VYM and VNQ have generated 5 or 10-year trailing returns of more than 7%. Similarly, REITs like OHI and Fundrise’s Income eREIT have historically paid annualized returns of 4.5% to 10.5%.*
Wait, looking at the historical prices of VTI, VYM and VNQ, I see that there are years where there have been very little or negative returns. What do I do if this happens during retirement?
Unfortunately, there will always be unavoidable down years. That’s why it’s important to have investments that consistently pay dividends regardless of changes to stock price. VYM for example has a dividend yield of 2.6% to 3.5%. Likewise, VNQ has a dividend yield of 2.1% to 4.4%. While these dividends are helpful, it’s crucial to remain flexible and to be prepared to work for some extra income when times are tough. For instance, before I quit my day job, I plan on establishing a reliable freelance business as an extra safety margin to tap into on an as needed basis.
To recap, planning for retirement is not always easy when living expenses and other variables are constantly changing. Nonetheless, it’s important to actively monitor past expenses and investment returns so that you know when you no longer need a full-time job to take care of your needs. As a start, figure out a flexible lump sum to save for retirement based on your current annual expenses. Then, invest your money in safe investments that are known to return at least 5% a year. By doing all of the above, you’ll be well ahead of your peers who’ll continue to rely on full-time jobs long after you’ve retired.
*REITs are required by law to pay out at least 90% of their taxable income in the form of dividends to shareholders each year.