I am 36 years old and I’m done saving for retirement. Does this mean I’m independently wealthy or that I never have to work again? Nope, not at all. It does mean that I don’t stress out over a distant future and that I can make value tradeoffs between income and lifestyle, in the here and now.
What if I were to tell you that I only have $400k saved for retirement?
If I were a betting person – which I’m not, because lotteries are, after all, for the mathematically challenged – you now suspect I’m a bit of an idiot. No one can retire off of $400k. You may be thinking to yourself, “Perhaps she plans on eating cat food in retirement?”.
Or maybe, just maybe, you’re one of the few people who understands compound interest, and by that, I mean that you understand that your brain doesn’t work exponentially.
If you want to get fancy, you can pull up an online financial calculator and follow along. Otherwise, I find it amusing to do most of my own financial planning on a piece of scrap paper, because it’s just as accurate* as something much more impressive with tables and charts and lots and lots of paper.
How I know I am done saving for retirement
Let’s get down to it! I’m 36 years old, and I’m assuming I’ll want to retire at 65. That means I have 29 years until retirement. Using the rule of 72, and assuming a rate of return of 5%, it means my money will double every 14 years. I have 29 years left, so I will get two full doubling periods. So my $400k will be ~$800k when I am 50 and ~$1.6MM when I am 65. Using a withdrawal rate of around 4% will give me an annualized income of $64k before tax. Assuming a do a real shitty job of tax management, I should have an after tax income of $50k. Which is about what I spend right now.
Retirement planning done.
Assumptions include: Reasonable investment return, inflation, tax free growth, taxes. This also assumes full capital preservation and doesn’t include additional savings in retirement accounts or CPP and OAS for me or my husband. So I guess I’m way overprepared.
You’ll notice there are two rules of thumb used in my calculation. The rule of 72, and the 4% safe withdrawal rate. Let’s explore these in further detail.
The Rule of 72
The rule of 72 allows you to estimate the effect of compounding without a financial calculator. You just divide the expected rate of return into 72 and it will give you the number of years it will take for your money to double. For example, if you felt that a 10% rate of return was reasonable, you could expect your money to double every 7.2 years. Or you could calculate that a 2% inflation rate would reduce the purchasing power of your money by half every 36 years. So a loaf of bread that costs $5 today would cost $10 in 36 years.
The 4% Safe Withdrawal Rate
The 4% withdrawal rate is commonly used to estimate how much of an investment portfolio could be withdrawn so that it could continue providing an income forever. It assumes a reasonable investment return of 7% over time and that the 4% could be increased each year to keep up with inflation, meaning you don’t lose purchasing power over time.
Often, people who are pursuing extreme early retirement will use a slightly smaller safe withdrawal rate, such as 3-3.5% to be conservative. But you could also argue that a 5% withdrawal rate would be much more reasonable for a conventional retirement, since capital preservation might not be your priority. You can’t take it with you!
Using the inverse of the 4% rule will give you a very close approximation for “How much is enough to retire on?”. The inverse of 4% is 1.0/0.04 = 25. Which means that once you have 25x your annual spending amount saved up, you could theoretically retire. In my case, if I desired $50k/yr, then I would need $50k x 25 = $1.25MM invested assets to be retired. Obviously, there are tax implications, investment risk, and fund accessibility issues to account for. But overall, the actual amount needed for retirement is a very simple calculation.
I’m using my retirement plan as an example to illustrate one way that compounding can be so confounding. Even with no additional growth assumptions (I’m assuming I don’t add another penny into my RRSPs), my money doubles twice. It does this because it has lots of time to grow.
Here’s the first big secret of compounding; Time. Compounding + Time = Shitloads of money. A really big mistake people make when thinking about retirement is allowing their emotions to guide them, and not using math. In this case, human emotions and math never line up.
We become concerned with retirement in our 40’s and 50’s and not when we’re in our 20’s and 30’s when we could have been lazy savers in comparison. You can still save for a healthy retirement starting in your 40’s, but you just have less doubling periods doing all the heavy lifting for you.
So sit down with your own napkin and work your numbers backwards. What do you currently spend? Remember to remove your mortgage and savings from this number as you won’t have these in retirement. What is 25x your spending? How many doubling periods do you have? Could you be done saving for retirement too?
*One of my least favourite classes in University was Probability and Statistics. Ironically, I use concepts from this class way more than any of the others. The class started with a discussion about precision and accuracy. You can make more precise calculations, but the results are not more accurate. Do not let the detail – the number of decimal places you have – lure you into a false sense of accuracy. Precision and accuracy are not the same thing. Then I joined the rest of my class and read Harry Potter for the remainder of the class. True story.