How much you need to quit your job
In today’s essay, Mark will show you – right here and now – how to work out when you can ‘retire’.
Obviously, we discussed last time that you should always have some form of active income coming in.
But this is more a case of saying how much you’ll need to stop worrying about money.
It’s a pretty exciting exercise.
In fact, scratch that – it’s huge.
This isn’t theory – you can really work out how much you need to save so that you can work towards true freedom. I’d say that’s huge.
Let’s get straight to it…
What’s Your Magic Number: Figuring out How Much Money You Need for Retirement
By Mark Ford
How much money do you need to retire? A hundred grand? A half-million? Ten million?
I’m getting ahead of myself. Have you even tried to calculate how much money you’ll need to retire? Chances are you haven’t.
The Employee Benefit Research Institute reports that 56% of workers haven’t made an effort to figure it out. Maybe that’s why statistics show nearly 75% of retirees haven’t saved enough and say they would save more if they could do it all over again.
How much money do you need, then?
In his book The Number, former Esquire editor-in-chief Lee Eisenberg talks about why “the number” is so important. He says that, for most people, it represents a free pass to a great life without financial stress.
That’s what it always meant to me. When I was in my 30s, I had a number in mind. It was a net-worth number. I was determined to achieve it in fewer than 10 years. And I did. But after retiring, I quickly discovered I was using the wrong number.
Net worth matters, but it is not “the number” you need to plan your retirement. Your net worth includes all assets — including your house and your favourite “toys” — which you may not be willing to give up in retirement.
That’s what happened to me. I wasn’t psychologically able to move into a smaller house, get rid of my little fleet of vintage cars, desist from buying fine art, etc. It was a big lesson.
Your Magic Number is how much you need to replace your active income and pay for your expenses… after you’ve quit your 9-5 job.
Because I used the wrong number, I had to go back to work. I picked a new number, a real number, and worked another 10 years to hit it. When that day arrived, I felt fantastic.
I also changed my priorities. Making money was no longer my No. 1 goal. I could spend more time on hobbies — some of which were businesses (such as my art gallery and my film production company) that had little chance of making serious money.
This is a good feeling, one I can recommend to you. If you haven’t had that feeling yet, I hope that what I’m about to tell you will put you on the right track…
Most people fail to achieve their retirement dreams, Eisenberg says, because they make two mistakes:
Many people enter their 40s and 50s “ensconced in a cloud of avoidance and denial about the years ahead of them.” They spend their early years not doing any serious retirement planning.
“They sense they are far behind from where they should be, but they don’t want to face the truth. These are the procrastinators,” Eisenberg says.
Other people do retirement planning, but they’re sloppy about it. They don’t know how to calculate their Magic Numbers correctly, so they pick arbitrary numbers and hope for the best. Eisenberg calls these people “pluckers” because they pluck numbers out of nowhere.
You don’t have to make these mistakes. They are actually easy to avoid. Let’s do that now. Let’s figure out how much money you have to save in order to quit work and enjoy retirement fully. I call this your “Magic Number.”
Five Steps to Finding Your Magic Number
I am going to give you five calculations. Each one should take just a few minutes. The entire process, including all five steps, should take no more than a half-hour.
Please do it now. In terms of your future wealth and happiness, it may be the most fruitful 30 minutes you ever spend.
Step 1 – Calculate How Much Money Your Current Lifestyle Requires
The first step is to calculate your Lifestyle Burn Rate (LBR). This is the amount of money needed each year to enjoy your lifestyle.
It’s easy to determine this number. Simply calculate how much you are currently spending to live life each year.
I find it helps to group the expenses into five categories: housing (including maintenance and taxes), basic living expenses (food, clothing, health care, etc.), education (if applicable), entertainment (including travel), and charity (if you believe in it).
This exercise may be illuminating. (When I redid it recently, I was shocked to find how much money I’m spending on cigars — $14,000!) You may find this exercise alters your idea of a quality life. (I’m cutting back to one stogie per day.)
It will also make it easier to make adjustments in the future, if your lifestyle changes.
Don’t guess at these numbers. Guessing, in my experience, correlates with grossly underestimating. Use your actual costs from the past year.
Your LBR is a critical number. Without it, you can’t make any other financial planning calculations — such as how much money you need to save for retirement. And that’s our next step.
The Three Stages of Your Financial Life
Your Lifestyle Burn Rate (LBR) is likely to change three times.
The first stage is up until you have your first child. The second stage begins when you have your first child and continues until your children are gone and their college expenses (if you are paying them) taken care of. The third stage begins after you are free and clear of dependencies, and it continues until you pass away.
If you have no budget or don’t have a clue how much you spend each month and year, try mint.com. It can sync with your bank account and make it easy for you to categorize your expenses. Once you do this, you can easily find out your LBR without having to add it up manually on a paper or Excel spreadsheet.
For most people, the first stage has the lowest lifestyle burn rate. You are young and relatively unburdened. If you are wise, you will limit your expenses to necessities and drink cheap wine.
The second stage, typically, has the highest lifestyle burn rate. You have larger home expenses, bigger basic living and entertainment expenses, and educational expenses for your children. For some people, this stage extends in time if you’re required to provide for aging family members.
The third stage has a LBR that will likely be twice that of the first stage, but significantly less than the second stage. This is — or can be — a wonderful part of your life during which you can enjoy traveling, hobbies, and entertainment without working more than you want to.
To complete this exercise, you’ll need to calculate your LBR for your current stage and for stages you haven’t completed. If you are in stage one, you’ll need to figure out your current LBR and estimate it for the second and third stages as well.
Step 2 – Adjust Your LBR to Account for Any Changes in Spending Patterns That Will Be a Part of Your Retirement Lifestyle
The next step is the one most people start with: deciding how much money you’ll be spending each year in your retirement to enjoy the lifestyle you want.
I just told you how to calculate your Lifestyle Burn Rate (LBR). What you are doing now is figuring out your Retirement Lifestyle Burn Rate (RLBR).
Take your current LBR, the one you just figured out above. Now add to it any “extras” you want to enjoy during retirement and remove any expenses you won’t have in retirement.
Let’s say, for example, that your current lifestyle burn rate is £80,000 per year. To make your retirement more fun, you want to own an extra car — a sports car — and join a golf club. This will cost you an extra £10,000 per year. Add £10,000 to the £80,000 and you have £90,000.
Or maybe you plan to travel all over Europe. Or you want to help finance a grandchild’s education. Regardless of what it is, here’s where you add in those anticipated costs.
Now subtract from that total number (in this example, £90,000) any expenses that you currently have but will no longer have when you are retired. This commonly includes expenses for your children and other expenses related to having a family with children.
For example, if those expenses are currently £15,000, you will deduct that £15,000 from the £90,000. That would leave you with £75,000.
Step 3 – Adjust Your RLBR to Account for Any Additional Sources of Income
The next step is to take your RLBR and subtract from it any income you are confident you’ll receive during your retirement. This income could include Social Security, a company pension, or side-business income.
For example, if you trust that Social Security will still be around when you retire, you can find out what your projected yearly Social Security income will be.
Slash that by 50% and subtract that from your RLBR.
You can do the same with any pension income you expect. And finally, if you intend to work part-time during retirement, you can deduct that, too.
Let’s get back to the example. Let’s say you just calculated your RLBR and found you’ll need £75,000 per year. To make these new calculations, you would deduct, say, £15,000 per year you expect to get from Social Security.
Then you’d deduct another £5,000 per year you expect to get from some pension. And finally, you’d knock off another £5,000 per year you expect to get by working as a golf ranger two days per week.
This reduces your RLBR from £75,000 to £50,000.
Should You Rely on Social Security?
It’s no longer a certainty that Social Security and your pension will be able to pay you the full amounts they should. Our Social Security system currently dispenses more money than it brings in. That makes the money you hope to receive from it in the future less certain.
The same is true with many pensions these days—too many pensions are terribly underfunded. This means that when pay out time comes, there’s a risk that some people won’t receive the income they’ve been promised.
On top of this, you have to factor in future rising inflation. As Social Security and pensions try to increase their current payments to match rises in inflation, it’s another drain on the already limited dollars in those accounts.
For these reasons, I want you to discount your projection of how much money you’ll receive from Social Security and pensions. Hopefully, you’ll get 100% of it. But to play it safe, I suggest you assume you’ll receive only 50%.
This is your Net Retirement Lifestyle Burn Rate (NRLBR). It’s an important number.
Step 4 – Determine What Rate of Return You Expect to Get on Your Savings
You’ve just gone through the steps to calculate your Net Retirement Lifestyle Burn Rate. In our example, that amounts to £50,000 per year. This is the amount needed to live the retirement you want.
There’s one last thing we must know before figuring out your Magic Number. It’s the rate of return you can expect to get on your retirement savings.
For instance, if you expect to get only 5% on your money, then your Magic Number — the amount you’d need to save before retiring — would be £1 million. ($1 million generates £50,000 per year at 5%.)
If you could get 10% on your retirement funds, you could retire much sooner… since you’d need only £500,000 at 10% to generate £50,000 in annual income.
So what rate of return should you plug into this equation?
That depends on what kind of investments you use. Most financial planners will spread your money into an assortment of stocks, bonds, and cash.
But I don’t like the idea of having my retirement fund in just stocks and bonds because the market can fluctuate greatly from year to year. [Asset allocation is the process of dividing one’s wealth into different asset types such as stocks, bonds, real estate, gold, and cash.]
With the asset allocation model, you should expect to earn a 10% return each year. We’ll update this expected return each year depending on market conditions. But for simplicity’s sake, let’s look at a basic example.
Let’s say you own investments in only three classes: stocks, rental real estate, and bonds. And let’s say you weighted your investments equally in each class. It would be reasonable to expect the following returns on those asset classes (after taxes):
Rental Real Estate: 12%
Since you have equal amounts invested in each asset class, that means your total expected after-tax rate of return would be 8% (the average of all three asset classes).
You now know how much money you need to earn annually to enjoy your retirement. And you know the rate of return expected from your lump sum of allocated investments. That means you have the tools to calculate your Magic Number.
Step 5 – Calculate Your Magic Number
To figure out your Magic Number, start with your NRLBR. In our running example, that was £50,000.
Now, divide it by the expected rate of return you just calculated.
Using the same example, you would divide the £50,000 (NRLBR) by the expected rate of return, 8%. Fifty thousand pounds divided by 8% (0.08) is £625,000.
That is your Magic Number! If you had this amount of money invested right now making 8% each year, you could retire.
If your net RLBR were £100,000, your magic number would be £1.25 million. If your net RLBR were £300,000, your magic number would be £3.75 million.
Get it? Just divide the income you will need in retirement by your after-tax expected interest rate.
In case you are lost, let me break it down for you again, using the original example. The following is just an approximation…
Check your bank ledger and credit card statements and figure out how much you spend each year (this is your LBR). In our example, this is £80,000.
Adjust your LBR for how much money you’ll need to spend during retirement to provide the type of lifestyle you want (this is your Retirement Lifestyle Burn Rate, or RLBR). This gives you £75,000.
Adjust your RLBR lower to account for any income you expect to receive during retirement. This gives you a Net Retirement Lifestyle Burn Rate of £50,000.
Determine the after-tax rate of return of all your investments combined that you can expect to receive on the money you have invested. In our example, that is 8%.
Calculate your Magic Number by dividing your NRLBR by your rate of return. £50,000 divided by 0.08 = £625,000.
Congratulations. You just figured out exactly how much money you need in order to retire. Write it down on a sticky note. Put it on your office desk or file cabinet. Always keep this number. The magic number you need to hit.
How Does Inflation Affect Your Magic Number?
When planning for your retirement, you have to consider the effects of inflation on the value of your portfolio. That’s because, in most cases, inflation makes future pounds less valuable than they are today. The £80,000 per year we’ve been using in this essay, for example, will still be £80,000 in 10, 20, or 30 years… but it will buy fewer things than it can buy today.
[Inflation is the rate at which the general level of prices for goods and services rise each year. For example, if inflation were 3%, the loaf of bread that cost you £1 last year would cost £1.03 this year. Its price went up… and because it went up, you’ll end up buying less bread this year.]
So how do you account for inflation in your Magic Number planning?
One way is by owning businesses that keep pace with inflation. Companies like this raise their prices to match inflation. Many of the stocks we recommend in our portfolio are of that kind. Having 20% of your portfolio in such stocks will help.
Bond yields should increase in the years to come as well. Today, they are low… and our plan is based on a 3% yield. But these are likely to increase in the years ahead. So that will help, too.
But the main inflation hedge you have in the portfolio I recommended is the rental real estate portfolio. Real estate, as a tangible asset, appreciates during inflationary times.
According to the Case-Shiller index, which has tracked real estate sales of existing homes since 1987, the average annual increase for real estate is 3.6% over this 25-year period. Compare that to the reported Consumer Price Index during the same period, at 2.9%.
More importantly, as a landlord, you should be able to increase your rent to match inflation. I’ve been doing that with my rental real estate portfolio for more than 20 years.
These factors should go a long way toward protecting the validity of your Magic Number. But if you want to be extra sure, you can simply use a smaller interest rate to calculate your Magic Number.
In our existing example, we’re dividing £50,000 by an 8% interest rate (0.08). This gives us a Magic Number of £625,000. But if we want to be more conservative, you could lower your interest rate to 7% (0.07). This would increase your magic number to £714,285.
If you have 20, 30, or 40 years to go before retirement, you might want to use a more conservative interest rate.
Your Personal Retirement Diagnostic: How Close Are You to Reaching Your Magic Number?
In “What’s Your Magic Number?” above, I gave you step-by-step instructions for how to calculate your Magic Number.
Remember, your Magic Number is the amount of money you need to have saved and invested in order to quit work and enjoy retirement. In other words, a lump sum of money that can provide interest income to live off of.
Now, we’re going to take the next step: We’re going to run a personal financial diagnostic. I’m going to walk you through a check-up to determine exactly how close you are to reaching your Magic Number.
I’m going to show you two ways to analyse how far along you are toward achieving your goal.
Using the first way, I’ll show you how long it will take you to reach your Magic Number if you keep saving money at your current rate.
Using the second way, I’ll show you how much money you must begin saving each year in order to reach your Magic Number by a specific future point in time.
Let’s get started.
Step 1: Calculate How Much Money You Have Already Saved
Write down how much money you have already saved toward retirement. This should include liquid assets (i.e., cash, stocks, mutual funds, and bonds in brokerage and qualified plan accounts or things such as gold).
It should also include any illiquid assets (i.e., an auto collection, a rare piece of art, or a second home) that you plan to sell prior to retiring.
If you live in a large house now but plan to live in a less expensive house in your retirement years, add expected profits from the sale into your retirement savings. But be conservative.
For example, if the house you live in now is worth £350,000 and you will be happy in a smaller house that will be £100,000 cheaper, add £100,000 to your retirement savings.
Do this right now. Figure out exactly how much money you have in retirement investments/savings today.
Step 2: Compare This Number to Your Magic Number
Let’s say you just added up all the money you have saved and invested and it amounts to £250,000. Our next step is to compare this to your own personal Magic Number, which I showed you how to calculate in the previous essay.
In our example from that essay, we discovered that our Magic Number was £625,000.
So now we take that Magic Number and subtract from it the amount we have currently saved and invested.
£625,000 – £250,000 = £375,000
We now know that we have to save an additional £375,000 before we’re able to hit our Magic Number and retire.
It’s here that we come to a decision point.
You have two options: You can calculate how long it will take you to save this £375,000 and reach your Magic Number at the current rate you’re saving. Or you could calculate how much money you’d be required to save each year if your goal was to retire at a specific time in the future.
Let’s calculate both, because each is useful.
Step 3: Calculate How Long Till You Hit Your Magic Number at Your Current Savings Rate
To do this, we look at how much money you’re saving each year. These savings can come from money you set aside from your paycheque. Or it can come from dividends you receive from stocks or other investments… maybe both.
Whatever the source is, it all funnels to the same place: your retirement savings account.
For this example, let’s say you’re able to save £35,000 per year from your paycheque and stock dividends.
Now we simply divide that £375,000 (the amount we still need to save) by £35,000.
£375,000 divided by £35,000 = 10.7.
This means that, at your current savings rate, it will take you nearly 11 more years to retire.
Is this good or bad?
Well, it depends on your age. If you’re in your early 50s and had planned to retire at 65, you’re in great shape.
But if you’re 58 and had wanted to retire at 65, this reveals that your goal isn’t realistic at your current savings rate.
Let’s say you just crunched these numbers and you’ve discovered you’re not saving enough to retire at 65. You’d probably want to know, “Well, how much would I need to be saving to make retirement at 65 a reality?”
That leads us to the second way you can analyse how to reach your Magic Number.
Should You Include Capital Gains in Your Calculations?
In Step 2, you compared how much money you’ve already saved toward retirement to your Magic Number. Whatever the difference is will be how much money you must save before you can reach your Magic Number and retire.
I said you’ll need to accumulate this amount of money through savings from your paycheque or stock dividends.
You might have noticed I didn’t suggest you should include any capital gains from your invested “savings” (for instance, if you’re investing your savings in a basket of safe stocks that are gaining value at 8% per year).
I did this to make things simpler. You could choose to include forecasted gains from your investments. And if you do this, it will shorten the expected time it takes you to reach your Magic Number. But I don’t recommend this.
That’s because not including these gains will give you an extra cushion. Unforeseen expenses will certainly arise that will eat into your savings. Not including these gains in your calculations gives you more breathing room.
Also, these are unrealised gains. That means they’re not certain. Therefore, if your projection is wrong, it will distort the accuracy of when you reach your Magic Number.
But if you decide that you want to include expected capital gains anyway, at least be conservative.
Step 4: Calculate How Much More Money You Must Save in Order to Retire at a Desired Time
You’re 58 years old. You need £375,000 more to retire. You want to retire at age 65. How much do you need to be saving each year to reach your goal by age 65?
It’s simple. First, calculate how many more years you have until you want to retire. In this case, that’s seven (65 – 58).
Then you just divide how much more money you need to save by seven.
In this case, that’s £375,000 / 7 = £53,571.
Is this realistic or not?
Well, compare it to your current savings rate.
£53,571 is about 50% greater than £35,000.
I think it’s unrealistic to think you could instantly begin saving 50% more money. That means either you’ll need to push your retirement date further back, or you’ll need to find a way to begin saving an extra £18,571 per year (£53,571 – £35,000).
Regardless of what you decide, going through this diagnostic process will tell you exactly where you are on your retirement journey, and how to get where you want to be.
Be Sure to Give Yourself an Annual Check-up
Doing all these calculations just one time won’t cut it.
The inputs are going to change over the coming months and years. Your income could change (a new job or promotion). And that means your retirement road map will change too.
For instance, what happens if your 16-year-old daughter gets her driver’s license… and proceeds to rear-end a brand-new £50,000 Audi?
What happens if your spouse’s deceased great-aunt leaves you an unexpected £100,000?
What happens if some of your investments turn south and your expected rate of return drops by half?
Unforeseen events that affect your finances are going to happen. And those events will alter your retirement plan. That’s why you should make this an annual check-up.
The Employee Benefit Research Institute recently conducted a study. It measured how confident Americans feel that they have enough money to retire comfortably.
The conclusion? The numbers came in at the lowest level ever in the study’s 23-year history.
But we are not counting you among those people. You now have the tools to take control of your retirement planning.
To summarize, first, calculate your Magic Number. Then, calculate how close or far off you are from achieving it. Then, make the decisions to earn more money or delay your retirement goals.