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Early Retirement Planning: What You Must Know

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If Retiring Early Is On Your Radar Screen Then Here Are Six Strategies You Must Know…

Early retirement planning is identical to conventional retirement planning with one big exception – time. You have less time to achieve your financial goals and more time that your money must last after you retire. What this means is you have a shortened, accelerated financial preparation phase and an extended post-retirement, spending phase when you retire early. Changing the time-frame will also change many other aspects of retirement planning – but not everything. It is important to understand the differences.

In other words, think of early retirement planning as conventional retirement planning on steroids. All of the conventional information about retirement planning throughout this site still applies to early retirement planning. You must still learn all the other stuff. However, certain aspects of retirement planning are magnified by the compressed time-frame, and the purpose of this article is to focus exclusively on those factors affected by this changed time component.

I encourage you to pursue the following strategies that can accelerate you into early retirement only after you have already built a strong foundation in conventional retirement planning. You didn’t learn to run before you could walk, and it is wise to build a solid foundation in conventional retirement planning before sprinting toward early retirement. Only after you have mastered the basics can you safely put your retirement on the fast track without adding excessive risk.

Remember, the unique twist to early retirement is all about time – less time to build wealth and more time to enjoy it. With that said, let’s begin…

Early Retirement Requires You To Build Assets Faster

Traditional retirement planning emphasizes traditional financial concepts like saving and passive investment strategies – otherwise known as the slow and secure path to wealth. It’s the same old stuff you’ve heard repeated ad nauseam – max out your 401(k) and invest the savings in a properly diversified portfolio using buy-and-hold. This works okay when applied judiciously over a 40 year career to finance a 30+ year retirement, but early retirees have shorter careers and longer retirements. That means they have less time to save and need more money to spend once retired. The traditional approach probably isn’t going to work.

The problem is passive investment portfolios only grow so fast – not nearly fast enough for those seeking early retirement.  Depending on the data and time period analyzed long-term returns vary from low to middle single digits net of inflation – hardly a rate to grow wealth fast enough for early retirement. Additionally, contained within this long-term data are 15 year periods where real returns are actually negative for a diversified, passive portfolio. That’s a mathematical disaster for someone seeking early retirement. (See the buy and hold myth section of this web site for more information on passive investment limitations.)

In other words, if you want to save and passively invest your way to an early retirement then think again because there won’t be enough time to compound the growth of the assets in a meaningful way. Losing compound growth as a wealth building tool due to the shorter time-frame of early retirement requires you to add a non-conventional dimension to your asset growth strategy. You must apply one or more of the following three principles…

  • Extreme Frugality: This is defined as being an extraordinary saver with low expenses relative to income. Some people have been known to save as much as 70% of their earned income to retire in 7-10 years. It is possible, but it’s not everyone’s first preference so let’s look at two other alternatives…
  • Active Investing: This is defined as adding a skill component to your investment strategies creating an additional return stream above and beyond passive returns. The higher investment return amplifies and accelerates the compound return. You can learn more about active investing here.

“Give me a lever long enough and a place to stand and I will move the entire earth”

Archimedes

  • Leverage: This is defined as expanding your resource base beyond your own limitations. Leverage allows you replace less time with more resources thus amplifying what you can achieve in the same amount of time.

For example, this author retired early at age 35 the hard way. I saved the bulk of my earnings (frugality) which I leveraged with specialized knowledge in investing (active investing) to increase the returns beyond passive buy and hold returns. This is a rare and difficult path to early retirement that few succeed with. It requires unusual skills both in personal finance and investing – something few people with regular careers possess or have the time to develop.

A more common path to early retirement is real estate because it offers financial leverage, business leverage, tax advantages, and the learning curve is very reasonable. There are many specialized strategies in real estate that shorten the time to build wealth by offering returns greatly in excess of passive investing. The common formula for these strategies is to find unusual value and/or add value using skill while magnifying the returns using the financial leverage inherent in mortgage financing.

“When a man tells you that he got rich through hard work, ask him: “Whose?””

Don Marquis

Another common path to early retirement is leveraging other people’s time through business ownership. Again, business ownership offers several forms of leverage and tax advantages not available to the passive investor. You can either follow your passion by building your own business or you can become an owner of the company you work for through option and stock bonuses.

In summary, there are three paths to wealth – paper assets, real estate, and business – but only two of these paths offer leverage (real estate and business). The conventional retirement planning approach uses the only non-leveraged asset category – paper assets. If your objective is to build wealth for a secure, prosperous, early retirement then the message is clear. The mathematics of saving and passive investing through paper assets is too slow thus requiring more time than someone seeking early retirement can afford (unless extreme frugality is your thing). You need an accelerated path to financial security using active, leveraged, asset accumulation strategies to reach your early retirement goals faster.

And if you are really in a rush then try combining all three tools – extreme frugality, active investing, and leverage – to really put your early retirement plans into hyper-drive.

Inflation Is The Number One Enemy Of Early Retirees

Now that you have built your assets, it is time to examine the issue of protecting your assets…

Inflation is an insidious cancer that eats away at the purchasing power of your savings. It is a nearly invisible tax on wealth that can destroy your financial security if you don’t plan appropriately. For early retirees this is particularly important because inflation has more time to do its damage. It is the number one enemy of early retirees.

A mere 4.5% inflation will cut in half the purchasing power of your money every 16 years. That means you must double your money during the same time period just to break even. A couple retiring in their 40’s with at least one partner making it to their 90’s can expect their purchasing power at 4.5% average inflation to get cut in half three times during their retirement. One dollar today would be worth little more than a dime when you are infirm and dependent. That is a very big deal.

If you think this example is far-fetched and can’t apply to you then think again. According to Charles Ellis in “Winning the Loser’s Game” $100 of goods in 1960 would’ve cost $500 in 1995 for a 4.8% annual compound inflation rate that destroyed 80% of your purchasing power. A retiree in 1960 would have to grow his portfolio and retirement income five-fold just to break even (and that doesn’t even include making up for the erosive effects of spending principal to support living expenses while paying taxes on all the capital gains along the way). To learn more about the impact of inflation try our free inflation calculator here.

“I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around (the banks) will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.”

Thomas Jefferson

If that weren’t bad enough, the unweighted stock market went the opposite direction during part of the same time period (late 1960’s to early 1980’s) and lost roughly 80% of its value when adjusted for inflation. How’s that for passive investment returns?  Or consider how the Dow Jones Industrial Average in 1993 was equal to its inflation adjusted level in 1928 – not exactly a real wealth builder in terms of purchasing power. In short, inflation isn’t just a problem – it’s the problem.

Nominal growth in assets deceives. The only growth that counts over the long run is increasing purchasing power. Unfortunately, much of the passive return from investing is little more than asset inflation showing up in higher security prices. As an early retiree with a long time horizon you must be very careful. Inflation is a tax on assets and the longer your time frame the more damage it can do to your real wealth – and real wealth is the key here.

Fixed annuities and pensions that don’t adjust adequately to compensate for inflation are a long-term recipe for disaster. Early retirees must structure their portfolio and income sources to grow and offset inflation’s erosive effects. Examples include income producing rental real estate, equities, and fixed income sources with adequate cost of living adjustment provisions.

The message couldn’t be more serious. Inflation is your number one financial enemy. Early retirees will be paying the inflation tax for a very long time and must plan accordingly. Anything less is financial suicide.

Early Retirement Spending Issues

Traditional retirement planning relies on spending to decrease over time as you age. The reason is because studies show spending is proportional to activity level (excepting emergencies and health issues) which decreases over time due to diminishing health and energy. This decreasing spending with age largely offsets the impact of inflation providing a relatively stable spending picture for traditional retirees.

Early retirement is different…

Studies of early retirees show spending often increases and remains high due to an active lifestyle and greater health. Not only do early retirees have more time for inflation to erode their assets, but they have more healthy, high activity years to pay for before infirmity kicks in near the end of life to decrease spending patterns. Early retirees can’t rely on decreased spending near the end of life to offset inflation like traditional retirees.

This means early retirees must fit into one of the following categories to achieve financial security:

  • Begin retirement with excess wealth beyond what is necessary to support current lifestyle so that you have an appropriate cushion.
  • Earn above market investment returns to overcome inflation and lifestyle costs during retirement.
  • Supplement retirement income with earned income.
  • Change lifestyle so that expenses decrease.

Most early retirees combine one or more of these four choices to make ends meet.

Early Retirees Must Remain Self-Reliant Until They Qualify For Social Security and Medicare

The traditional retirement three-legged stool for income that included pensions, savings, and Social Security is often reduced to one or two legs for early retirees. The missing leg, of course, is Social Security and Medicare because most early retirees are too young to qualify.

“I believe that all of us ought to retire relatively young.”

Fidel Castro

Eliminating government retirement programs from the early retiree’s financial picture places an increased burden on savings and other sources of income. Early retirees can’t rely on Uncle Sam to help with their retirement – at least for a few years. That means you must budget for lower income in the early years until Social Security kicks in, and you must plan on higher expenses to self-insure your health until you qualify for Medicare.

In short, the time gap between early retirement and traditional retirement poses an additional financial burden that must be carried by the early retiree – both in terms of decreased retirement income and additional health insurance costs.

Early Retirement Requires Perpetual Income Without Spending Principal

Financial planning for early retirement requires a nearly perpetual income stream that you can’t outlive. The reason is simple math. A couple retiring in their 40’s has very good odds of at least one spouse surviving into their 90’s. That’s 50 years of life to support. Even if you started retirement in your 50’s your going to need to plan for 40+ years. That is a lot of time.

To understand how this extended time in retirement affects spending investment principle imagine a traditional 30 year mortgage. The early monthly payments contain very little principal and the later payments are nearly all principal. The same thing is true when living off your assets in retirement – the early payments can spend very little principal but the later payments can spend lots of principal. The only problem is you never get to know when the last payments will be until it is too late.

Your longevity is unknown in retirement. You have no choice except to assume an extended life because the alternative would mean running out of money when you need it most. Most retirees are more afraid of outliving their money than they are of dying – and rightly so. Nobody wants to end up elderly and indigent. Therefore your monthly spending for an early retiree should leave principal intact until the end, and by the time you know it is the end it is too late to spend it anyway so who cares.

What this means is a 30 year time horizon (traditional retirement)  allows very little principal to be spent and a 40 to 50 year time horizon (early retirement) needs to be, for all intents and purposes, a perpetual income stream that can increase over time to offset inflation. But how do you do that? Traditional retirement planning doesn’t offer a solution.

As it turns out, the process for perpetual income planning is even simpler to figure out than traditional retirement planning although it is harder to accomplish. The various assumptions and estimates required by all the traditional models become unnecessary and pointlessly complicated when planning an early retirement. (For a complete explanation of how much money you need to retire please download this ebook – below is a brief excerpt…)

“The ability to simplify means to eliminate the unnecessary so that the necessary can speak.”

Hans Hoffman

For example, this author has been financially “retired” since age 35 in the sense of not earning income to pay living expenses. How can I do this safely when I can’t possibly estimate my investment returns, life expectancy, spending patterns, or inflation with even the faintest degree of accuracy over a 60+ year future?It would be an impossible task using the traditional models, but is actually rather simple to accomplish using a simple three rule system I developed…

(1) The first rule is you must build an investment portfolio sufficient to throw off residual income in excess of personal expenses. Please note this does not refer to total return, but only to residual income. You can only spend the income thrown off by the assets, but the assets themselves can never be touched. This distinction is critical.

When the cash flow from your portfolio is more than you spend on living expenses then you are infinitely wealthy. No complicated math required. At this point your life expectancy is irrelevant because you can never outlive your income making the expected lifetime assumption irrelevant.

(2) The second rule is you must manage your assets so that growth (total return-income) is greater than the inflation rate. This takes care of the inflation monster. For example, if your income comes 100% from a laddered bond portfolio then your growth is zero because total return and income roughly equal each other over time. This means that over the long-term the inflation monster will likely eat your all-bond portfolio for lunch when you live off the income. Not a good thing.

Alternatively, if your cash comes from appreciating assets like properly valued, dividend paying stocks and positive cash flow rental real estate then over time those assets are likely to grow with inflation and your income should likewise grow. As long as the difference between your total return and the income from your assets exceeds the rate of inflation then you can remove any need to estimate future inflation from your calculations. It becomes a non-issue.

(3) The third and final rule is your residual income must come from multiple, non-correlated sources. A reasonable mixture of dividend paying stocks and income producing real estate would satisfy that requirement. It is also possible to mix in some passive business income, fixed annuity income, royalty income, social security income, pension income, and other sources as well.

What you don’t want to do is retire based on one source of income. For example, many airline employees retired solely on their pensions that got decimated when certain airlines went through bankruptcy and restructuring. They had no fall back position and had to cut lifestyle and/or go back to work.

“There can be no real individual freedom in the presence of economic insecurity”

Chester Bowles

(4) A fourth bonus rule also exists, but it isn’t necessary. Think of this bonus rule as an insurance policy against the unknown factors in life ruled by Murphy’s Law. Don’t begin early retirement until your passive investment cash flow exceeds what you spend so that you have money left over to reinvest. This provides the last added measure of insurance to cover against unexpected surprises, lost income due to default, catastrophes, excess inflation, etc. By reinvesting excess revenue it allows you to compound your way to recovery over time from any adverse circumstance.

There you have it – four simple rules with no arcane assumptions or calculations that simplify how perpetual financing for early retirement works. (Again, to get the whole story explaining how much money you need to retire get the ebook here.) It doesn’t matter how early you retire or how long you live. As long as you adhere to these four simple rules perpetual financial security should be yours throughout retirement.

Money Is The Means To An Early Retirement, But It Is Not The End

What are you going to do with the 2,000+ hours currently spent working each year after you retire? If you think a fulfilling early retirement is all about the pro-leisure circuit, reading novels, playing golf and stuffing your face with popcorn while watching daytime television then think again. For most people the joy in that lifestyle is short lived.

The key to a successful early retirement is to know in advance what you want to do with all that free time. Like it or not, humans are goal seeking, social, productive creatures by nature – at least, most of us are. Anyone with enough drive and brains to succeed at building an early retirement will bore quickly with full time leisure. The studies prove it and this author’s personal experience is consistent with that conclusion. It is a mistake to retire early with only some vague notions around recreation, freedom, flexibility, spending more time with family, and “sticking it to the man”.

When you choose the goal to retire early it should be motivated by moving toward a new lifestyle that is more compelling than your current lifestyle. You need a passion or activity that stimulates you. You’ll need to find an interest congruent with your values that is exciting to wake up for and gets your creative juices flowing.

For example, this author is building a financial mentoring business because I’m passionate about personal finance, investing, and helping others achieve the life of their dreams by understanding how the process really works. This specialized knowledge has allowed me to retire early, and I enjoy sharing it with others. It is fulfilling and was my next step in my life’s journey.

“The greatest use of life is to spend it for something that will outlast it.”

William James

What will be the next step in your life’s journey? Some retirees blend part-time work, stint work, volunteering, the arts, launching new businesses, and any number of other occupations to add depth, human connection and productivity to their day. Other retirees spend more time at the gym and exercising to improve their health. Still others use the extra time to convert a previously loved hobby like flying, travel, or art into an occupation. None of these are mutually exclusive: you can combine them in any way that suits you. Whatever makes you happy is good enough.

There is no right/wrong answer to a fulfilling early retirement – different strokes for different folks. You just need a compelling reason to wake up each day that is bigger than your personal self-absorption. You will want to participate in the world, be creative, and remain connected. You will want an active social network, excellent health, interests, and the money to enjoy all of it with.

Don’t make the mistake of thinking full time leisure is what retirement should be all about – that’s a myth. Also, don’t make the mistake of thinking money is what retirement planning should be all about – it’s much bigger than that. Retirement planning must include life planning too, because in the end retiring early is all about enjoying a fulfilling and complete life experience.

Money is just a means to an end, but quality of life is the end in itself.

Early Retirement Planning Issues Summary

So there you have it, six critical issues that can dramatically impact your early retirement planning. Below is a quick review…

  1. You can’t rely on passive compound growth to build your assets for early retirement because there is not enough time. You will want to apply one of the following three principles to step on the accelerator pedal and grow your assets faster – extreme frugality, active investing or leverage. Combine all three to supercharge your asset growth and retire even faster.
  2. Inflation is the number one enemy of early retirees because it destroys assets over time – and early retirees have lots of time after their portfolios are built. You must design your portfolio so that it is protected from the ravages of inflation.
  3. Early retirees typically have different spending patterns from traditional retirees because they lead a more active life. You must plan your budget to compensate for this higher expected spending level.
  4. Early retirees face a period without the base support provide by Social Security and Medicare and must plan a “bridge budget” to compensate for this time period where income will be lower and expenses higher.
  5. Early retirement requires you to build a perpetual income stream because your assets must last so long that essentially no principal can be spent – only income.
  6. Early retirement is all about lifestyle – not budgeting, income planning, and investing. Make sure you get a life beyond the pro-leisure circuit because you are going to be living it for a very long time.

In summary, early retirement is one of my favorite subjects. It was my life dream that I have been living real-time since 1997. All the lessons shared above are based on my personal experience from walking the talk. If you share this life dream then maybe it’s time you consider early retirement coaching with someone who understands the subject intimately so that you can accelerate your progress and shorten your learning curve in achieving this very desirable goal.

Let me know how I can help…

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