How Financial Independence / Retiring Early Actually Works

Jennifer writes in with a great question:

I don’t really understand how early retirement works unless you have a giant income. If you have $1 million, that’s only $40K a year for 25 years, right? And it doesn’t count inflation which is going to make things progressively harder. I understand investing helps but that makes things even more risky. Saving even $1 million is ridiculously hard for the average American. How can this work? Can you explain how it could ever work for the average American?

The idea of “early retirement” and “financial independence” (often described under the FIRE acronym, for Financial Independence / Retire Early) is having a minor cultural moment right now. I’ve heard mention of it on NPR and seen articles about it in quite a few publications. A number of readers have sent me this article about Suze Orman’s claim that you need at least $5 million in the bank to retire early.

Walking away from the grind of a career in one’s forties or fifties seems like a wonderful thought, but for most people, it can feel like a pipe dream. It’s usually described and treated as completely unrealistic for most people and requiring a huge income to be able to pull it off.

Yet, it’s a goal that Sarah and I are working towards. Our combined income is within a reasonable stone’s throw of the average American household income and we’re on a path to be able to easily retire in our fifties.

How does the math really work for all of this? Can the “average American” really retire safely in their fifties or even in their forties if they plan ahead carefully? Let’s dig into the numbers and find out!

Defining the “Average American” and Other Basics

The first thing we need to do is dive into this idea of the “average American.” This is a very tricky thing to answer, because the income of the average American household depends on how you define “household” and also how you define “average.”

First, let’s consider different meanings of the word “household.” According to 2014 tax data, the average income by household varies a lot depending on the type of household. For example, the average married couple filing jointly in 2014 reported earning $117,795, while the average single non-widowed person reported earning $34,940 for the year. That’s a huge difference. According to the Census Bureau, the average household income in America across all households was $72,641.

So, should we use that number? Well… it depends on how important you consider the “average” number. The “average” household income means you add up all incomes in America and divide by the number of households, right? That’s great, except that the households making a huge income unfairly skew the average. For example, if you have one household making $10,000,000 a year and 99 households making $10,000 a year, the average household in that group is making $109,900. That doesn’t seem like a sensible number to use, does it? That $109,900 number really isn’t useful to anyone – not to the family making $10,000,000 nor to the 99 families making $10,000.

A better number to use here is the median income. The median income is simply the number you get when you line up all of the household incomes in America by the size of their income, then find the one in the middle of the line. So, in that $10,000,000 example above, the median income is $10,000, because that would be the income of the family in the middle of the line. The US Census Bureau reports that the median household income in 2017, the most recent year available, was $61,372. So, that’s the number I’m going to use.

(Notice the difference between the average household income – $72,641 in 2014, the most recent data I could find – and the median household income – $61,372. Why the disparity? As I noted above, it’s because high income earners skew the average upwards. Some people earn way more than others in America.)

So, we have our baseline income – $61,372.

For inflation, we’re going to use a 2% rate, which is pretty normal inflation over the last 20 years. It has been somewhat higher at times and lower at different times, but that’s a reasonable average.

We’re also going to use an average annual return for our investments of 10%, which is the long term average annual return of the S&P 500. If you invest in something like the Vanguard 500 over the very long term, you’re going to get a 10% return on average for your money, and it’s something pretty much anyone can do.

The Trinity Study – How It Works

Let’s turn our attention now to the “Trinity Study.” The “Trinity Study” refers to a research study done in 1998 by three professors at Trinity University, entitled Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable.

The study concluded a number of things, but the big conclusion that stands out for a lot of people is that a retiree with a suitably allocated $1 million portfolio could withdraw $40,000 the first year, give herself a cost-of-living adjustment every year afterwards, and have a 98% chance of the portfolio lasting at least 30 years.

In other words, if you’re suitably invested (meaning an investment portfolio that’s largely stock-based – in this case, 75% stocks and 25% bonds), you can withdraw 4% of that initial investment each year and have a 98% chance of the investments lasting for at least 30 years.

If you look at some of the details of that paper, however, if you cut your withdrawal rate to 3% and invest in a portfolio that’s either 50%/50% between stocks and bonds or 75%/25% stocks and bonds, you have an extremely high chance of that portfolio lasting forever. If you cut the withdrawal rate to 2.5%, it becomes a mortal lock.

So, let’s say you have $1 million in investments and you invest it ideally according to this study – something like 75% stocks and 25% bonds.

You decide to take out $40,000 a year. There’s a 98% chance that your investment will last for 30 years or more.

Let’s say you decide to go for a 3% withdrawal rate and withdraw $30,000 a year. In that case, there’s a 100% chance that your investment will last for 30 years or more and a very good chance that it will last through the end of your life.

Let’s say you decide to go for a super-safe 2.5% withdrawal rate and withdraw $25,000 a year. In that case, it is exceedingly likely that your investment will last through the end of your life, no matter how long you live.

The conclusion of the Trinity Study can best be summed up as this: if you invest your money sensibly and withdraw it at a relatively low and steady rate, it almost certainly will last for the rest of your life.

The Trinity Study Meets the Median American

Remember, earlier on we noted that the median American household brings in $61,372 a year. Let’s assume that this family would want to be able to pull that much out of their investments each year.

If they’re going for the fairly aggressive 4% model, the one that has a 98% chance of success over 30 years, they’d need $1,534,300 to invest.

If they’re going for the 3% model, the one that’s 100% likely to last 30 years and pretty likely to last a lifetime, they’d need $2,045,800 to invest.

If they’re going for the 2.5% model, the one that’s extremely likely to last a lifetime, they’d need $2,454,880 to invest.

Those numbers seem pretty large, but there are a bunch of factors to consider that make it a lot more doable than one might think.

How Much Will You Actually Need When Retired?

Most models of early retirement vary in terms of how much money a person would have to have per year when retired.

For example, one model, often referred to as “lean FIRE,” leans on the idea that a household really doesn’t need that much income to make ends meet if they’re living a simple lifestyle and don’t need to keep up with the rat race. In this model, a family might withdraw, say, 125% of the federal poverty level for a household of four, which is $31,375. Remember, this family no longer needs to work – they don’t have to commute, they don’t have to eat out at lunch, they don’t have to buy work clothes, and they have a whole lot more spare time to do things for themselves. Plus, they’re also paying much lower taxes. This family’s standard of living really wouldn’t decline all that much, to tell the truth.

If you look at the $31,375 a year model, the aggressive 4%/year strategy needs only $784,375 in investments to make it, and even the super-conservative 2.5% strategy only needs $1,255,000.

The reality is that if you’re intending to live a “lean” retirement lifestyle, the threshold of savings goes down substantially.

For Sarah and myself, we’re aiming to not live this lean, but we are aiming for a much leaner lifestyle than we have right now. Sarah will no longer commute, for example, and we’ll no longer have five people living under our roof, just two. Those things are going to save us a bundle compared to how things are right now. Sarah and I don’t live a particularly extravagant lifestyle, either.

Another Option: Barista Mode

Another approach to this problem that many people take is that they plan on getting a part time job of some kind to supplement their income, just because they enjoy the routine of working and the interaction with coworkers and customers, so they aim for a low-pressure and low-intensity service job that doesn’t need to pay well, but supplements their “financial independence” planning. Others might just want to work at a “dream job” that won’t necessarily pay well, but they’re going to really enjoy the work, like someone taking a job as secretary at their church or something akin to that. This is sometimes called “Barista FI;” I like to call it “barista mode.”

If someone works for 20 hours a week for 40 weeks a year making $10 an hour, that provides $8,000 of their annual income. If you combine that with the “lean” numbers described above, you knock the required “lean” number down to $23,375 per year, which brings even the super-safe 2.5% per year model down under $1 million.

What About Inflation?

One tricky part of this entire discussion is the specter of inflation. Like it or not, inflation happens, and prices are constantly going up. As I noted at the start, 2% a year is a pretty reasonable estimate, but that means that every 30 years or so, all prices will double. The things you buy for $25,000 right now will cost $50,000 in thirty years.

This is where the model begins to struggle a little bit, because it makes no assumptions for inflation. The numbers start getting sticky, but the strategy I’ve seen discussed the most often is to start off with the 2.5% per year model, then slowly increase that amount along with inflation. During the early years, you should be withdrawing so little that your investment total is still going up rapidly, perhaps enough so that the inflationary increases won’t end up causing a disaster.

In short, inflation is the big reason why I lean strongly toward the 2.5% model.

The Role of Social Security

What role does Social Security play in all of this? The vast majority of Americans will begin receiving Social Security benefits of some kind when they get into their sixties. What about that?

Many people like to calculate early retirement numbers assuming nothing from Social Security, treating it as a “bonus.” They do this out of doubt for the future of the system.

Others rely on Social Security for their calculations, treating it as a significant reduction in how much they’ll have to withdraw when they hit a certain age. This often makes plans using a 3% or even a 4% withdraw rate last into perpetuity.

For example, a person making the median annual household income – – would start receiving $2,103 a month, or $25,236 a year, in Social Security benefits at age 67. If you’ve chosen a “lean FIRE” model, that reduces your annual withdrawal from $31,375 down to $6,139. You won’t need much in savings at all to live for a very long time on $6,139 per year, even if it creeps up with inflation.

I tend to assume Social Security will be there for me at the currently stated benefit levels. If it goes away, there’s a very good chance that there’s economic calamity happening on such a level that this entire plan really doesn’t work.

So, What Do You Really Need?

This starts to seem really complicated, but it really all comes down to how much money you’re going to need to take out each year to live. The less money you need, the less you’re going to have to have in order to retire early.

Sarah and I are going for the safe 2.5% model with a starting withdrawal rate of around $30,000 a year, except that we’ll adjust our withdrawal each year for inflation and then we’ll subtract out our Social Security benefits when they start rolling in. So, our target number is around $1.2 million ($30,000 divided by 2.5%).

So, let’s use that as our target number. To be able to retire with a “lean” lifestyle, you’ll need something around $1.2 million in the bank. Different factors can change that number – are you going to work a part time job? If so, the number is higher. Do you need a little more than $30,000 a year? If so, the number is lower.

So, How Does One Get There?

Let’s say that a person is fresh out of college at age 22 and is making that national average, $61,372 a year. They want to get to $1.2 million in savings as fast as possible, remembering, of course, that their target number is going to grow at 2% per year, but so will their salary. We’ll use those as constants.

Let’s say this person chooses to live a lifestyle at 125% of the federal poverty guideline – $31,375 a year. This gives them almost exactly $30,000 a year to invest for retirement, an amount that will also grow at 2% per year. Let’s say that person puts it in the Vanguard 500 for the long term – as mentioned at the start, that has an average annual return of very close to 10% over the long term.

The person that follows this exact recipe would hit their early retirement target at age 40 and walk out the door on their 41st birthday or thereabouts. They would have $1.835 million in the bank and would need to be withdrawing about $43,000 a year thereafter, inching up 2% a year for inflation. In their 60s, they’d start earning Social Security benefits.

In other words, a person fresh out of college earning the median annual salary for an American who chooses to live at 125% of the federal poverty guideline and then puts every extra dime of their income away for retirement can retire early at age 41 and likely never have to work again.

This doesn’t include a lot of factors, of course. It doesn’t consider student loans as it assumes they’re paid back out of the $31,000 a year the person is living off of; if that doesn’t work out, it slows down the plan. It doesn’t consider raises, either, which might be used to accelerate this whole plan. It also assumes lifelong contentment on a low income, something we’ll touch on again in a minute.

The point is this: the median American, with suitable motivation, can most definitely retire early, even very early.

The Real Challenge: Living with a Low Income

The challenging part of all of this, and the reason many people argue that it can “never” work, is that it requires people to live on a lower salary than most Americans are comfortable living on.

Making ends meet on an annual gross income of around $30,000 a year means a monthly take-home of about $2,000 or a bit more. Out of that comes the rent, the food, and all of the other expenses a family might incur.

That’s not to say it can’t be done, just that it requires a lot of sacrifice that most people aren’t willing to make. Imagine, for example, choosing to have no cable at home and only having an over-the-air antenna. You choose to have no internet at home. You choose to have no cell phone plan and instead use a cheap pay-as-you-go phone for $20 or $30 a month. You live in a small apartment. You eat out only rarely and make almost all of your food at home using staple foods and store brand items. Your entertainment largely consists of free community activities, checking out books and DVDs from the library, and getting exercise at the park. Maybe you work a part time job to accelerate your savings.

That’s the real picture of someone on a median income wanting to work toward retiring early. It’s not a life that most Americans would choose at that income level. They’d view living in a high cost of living area and/or home internet and/or a cable plan and/or a cell phone plan and/or regular meals at restaurants and/or regular entertainment expenses as a baseline for living a modern life, and if that’s your baseline, it is pretty close to impossible to follow this plan.

An additional problem is that half of all Americans have a lower household income than this. The lower your income is, the further out your retirement age goes. (Of course, in this scenario, transitioning to living on a tighter income to make this work is easier, as you’re already accustomed to frugal living.)

The Fallback

The final thing to remember in all of this is that the fallback is simply going back to work somewhere. It’s not apocalyptic if something doesn’t quite click. If it doesn’t look like things are going to work out, just go back to work for a few years and you’ll almost definitely fix the problem just by living off of your own earnings for a few years and letting your investments rest and build, and maybe contributing a little to them. After that, you can probably hop right back on the early retirement train.

If Sarah and I both retire at, say, 50, and then we realize around age 60 that it isn’t going to work forever, well, we’ll both go back to working for a while. We’ll live off of whatever we make for a few years, let our savings build up without interference, and then “retire” again at 63 or 64, when Social Security is just about to come online for us, and then from there on out, we’re good.

That’s the downside of this plan – you just have to work again for a few years. It’s not a disaster by any definition of the word.

Final Thoughts

Here’s the truth: the median American can absolutely retire early, even in their forties, but it requires diligently sticking to a low-income lifestyle for life. That type of commitment isn’t something that most people are willing to commit to, especially when their income opens the possibility to a lot of lifestyle perks.

When you start adding in things like home internet service or a cell phone plan and a decent phone and a cable service and Netflix and eating out with any regularity and nice clothes and a decent car and occasional entertainment and a trip once in a while with your significant other, you’re living a lifestyle above what it would take to retire in your forties because there isn’t enough money left over after all of that to save enough to make retirement in your forties happen. You can perhaps aim for your late fifties.

It gets even more challenging if you’re not starting right out of college or very soon thereafter. If you’re just starting to figure this out in your late thirties, you’re aiming for a normal retirement; your retirement savings are simply going to nicely supplement Social Security when you walk out the door in your sixties.

All of these factors together make it pretty hard for the “median American” to pull it off. They have to start really young. They have to be willing to live a pretty low income lifestyle. They have to not have any exceptional negative financial factors in their life, like huge student loans or a lot of dependents or anything like that.

However, if you get past all of those things, the “median American” can most definitely retire early. It’s just not a path that many will choose to walk and, for some Americans, extenuating life circumstances make that path nearly impossible.

Of course, earning a higher income makes all of this easier, from beginning to end, but this plan is not out of reach of the median American. It just requires a lot of hard work and a little bit of luck.

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