A Test for You: 40-years Old and No Mortgage
Can they retire early?
July 2. How do you feel about your household economy?
Two months from the start of a new academic year and at the completion of my book chapter on retirement. Will my juniors and seniors care about retirement? In my experience, not as much as their parents. Most weeks during the term, students are thinking about Thursday night.
In a different light, the brightness shone by friends who had graduated and nabbed their first jobs have had some knowing retirement is a thing. They may have heard of a 401(k). “Jenny had to figure out how to invest for retirement, and she got an employer match,” said a front-rower. Among new job entrants, salary is numero uno, and a signing bonus is remembered, but after that, employee benefits can be an afterthought for a newcomer. Not for employers. Total comp is numero uno, and benefits are expensive.
What does early retirement mean to you? Has it begun, imposed on you because of choice, good fortune, poor health, or unemployment? Are you in your twenties with a new job and a 401(k) match, left to ask HR what to do because contemplating retirement is unrelatable?
A Scenario for You to Judge
Perhaps you have an opinion about a younger couple, around forty, with one income and two children under age four, who want to retire by age sixty. A short remaining work life, a long lifetime, and daughters to educate. What would they need to pull off an early retirement, and how would you measure the chance of success? (If we were having a dialogue, this is when I would pause and listen.)
The answer begins by understanding that each household has its own life, family, and finances. Ten million dollars in Nvidia stock may not help a wealthier household pull off the retirement they prefer, but the daughters will get educated. A poverty-level salary will preclude an early retirement at any level, and a family contribution to education costs is impossible. There are many households in between, and the answer to early retirement is not always more money. The best living standard within the bounds of a household’s resources and preferences for bequests is the right way of thinking about a solution. Any household with an interest in retiring at some specific date has two questions to answer,
Can we retire at our preferred date?
What would be our highest living standard path to meet this early retirement objective?
Last week, I read about a couple who live in Kansas City, ages 38 and 40, on a single income with two children contemplating retirement and following the FIRE movement. “Financial Independence, Retire Early” is their goal, which they characterized by the following statement:
“Long term we would like to have enough passive income to not have to work full time into our 60s.”
The “KC FIRE” couple participated in ’s Home Economics Series. They shared a listing of their expenses, actual details about how they spend money, and their asset-debt mix. They value frugality and financial flexibility and aspire to retire very early. Left unanswered was whether they could meet their age-60 retirement objective. They stated, “We have been following the FIRE movement our whole marriage, and we have a goal of reaching $2.5 million in assets and living on 4% a year.”
What does your gut tell you about their plan?
Analysis
Here are some details for you to make an initial judgment. KC FIRE owns their $400,000 home, has a pre-tax earned income of $128k, receives $20k of family money each year, and has two children under the age of four. Their annual expenses before tax considerations are about $100k. Like me, you might vote that retirement by age 60 is not in the cards, but your opinion might change.
Consider KC FIRE’s asset information
KC FIRE’s financial assets are pretty darn good. Checking and savings account values total $108k, defined contribution plan values, e.g., 401(k)’s total $980k, a brokerage account totals $900k, and there is room for $53k in a Roth and a 529 education funding plan for the daughters. An HSA (health savings account) has $80k in it. Now, how might you vote on meeting their early retirement objective? The likelihood of meeting the goal is higher, but many years exist to navigate. A 40-year-old with an age 60 retirement target has many more years in retirement than work years. If longevity runs to a max-age of 95 for each, that puts more pressure on resources to perform.
What don’t we know
There is a lot we don’t know about KC FIRE’s finances. For instance, whether the husband who became recently unemployed after earning $150k per year will re-enter the labor market to supplement his wife’s $125k income. Let’s keep him at rest and assume he is “out” to pressure the early retirement objective more. Sidebar: KC FIRE has daycare expenses of $2,200 per month that Dad can replace if they choose.
In addition, there is no information about how financial assets are invested. Still, for this analysis, we assume non-retirement and retirement assets earn a long-run return that matches expected inflation, a 0% real return, which is very conservative.
There is some uncertainty about the plans for the daughter’s future education. Who knows how much the traditional educational landscape will change in fifteen years? Today, there is a significant variation in education costs, and we assume a distinctly different cost than today’s $350k spent for an elite four-year education with resort amenities and inhibitions on free speech. State schools can be had for less, and here we assume a four-year $50k annual cost, in today’s dollars, for each of the daughters when they turn 18. New contributions to the existing 529 plan will fund these future costs.
Lastly, we assume Social Security retirement benefits will be pulled at age 70, typically the best choice for individuals expected to live a long life. Because the level of benefits is related to actual income earned, we assumed a reasonable past earnings history for the couple up to this year.
Insights
Let’s start with KC FIRE’s annual expense total, listed in the graphic below. Today's spending is approximately $102k, but that doesn’t include taxes or any new contributions for their daughters’ college education.
Suppose we add Missouri state income taxes, federal tax, FICA tax, and new 529 contributions back in. Are they within the budget that fits into a sustainable lifetime objective of retiring at age 60? You will notice that $156k of expenses exceeds $125k of earned income. Is it panic time? It is not because KC FIRE’s non-retirement assets are significant, and withdrawals from checking, savings, and brokerage accounts can pay their bills for a very long time.
At age 60, retirement assets play their role and partially replace the loss of earned income; at age 70, Social Security retirement benefits provide their share. Using economic methods that determine the best living standard path, KC can make their 529 contributions and have an additional $3,166 for spending. We know this because I built an economics-based financial plan for KC FIRE using MaxiFi. KC FIRE’s assets and expected resources, the “magic number,” recommended discretionary spending, is the economics-based solution to KC FIRE’s financial objective of retiring at age 60. For KC FIRE to implement their plan, they can spend as they currently spend plus an additional $3,166 as they see fit, and sock away $26,015 into the 529 Plan.
The snapshot above is for the first year of the plan. Future years are reported in the complete plan, which can be found at the bottom of the page on my site.
KC FIRE’s example offers a takeaway for all subscribers. Planning to accumulate a pot of money by your target retirement date and living on 4, 5, or 6 percent rate will not inform you about your highest, sustainable living standard. If you read a personal finance columnist or work with an advisor who thinks spending down suggestions are state-of-the-art, know that is like your anesthesiologist telling you to bite down on a stick to help your pain. We have more knowledge and better technology.
Investments are Risky
Lastly, I thought KC FIRE would be interested in the role of investment risk, and not knowing how they allocated their assets to investments, I played what-if with a particular investment mix. The optimal plan was developed assuming both non-retirement assets and retirement assets were invested 80% in the Total Stock Index and 20% in the Total Bond Index. Annual projected discretionary spending amounts embodied the investment risk associated with the variability of these investments. Simulated were 500 spending trajectories and the 25th percentile line (75% of the trajectories were above it) identify a moderately worst-case scenario for spending, and the 75th percentile line (25% of the spending trajectories were above it), the moderately best-case scenario for spending while satisfying the age 60 retirement objective. In other words, given how assets will be invested if KC FIRE retires at 60, the lines below trace annual living standards dependent on future investment performance. Is KC FIRE happy with this set of potential living standards? It is their call. But, if they like today’s living standard, which includes funding their daughter’s education, retiring at 60 is workable.
Raising the Living Standard
If KC FIRE wants to increase their living standard, there are paths within the family choice set. At this point, the husband is retired forever, which doesn’t have to be the case. Furthermore, the age 60 retirement objective could be pushed to 62 or 67, whatever KC elects. And, there is more room to increase investment risk while maintaining diversficiation.