Tuesday, April 5, 2011

Simple Early Retirement Calculation

Early Retirement Calculation
There's a simple calculation that you can use, that can give you a rough estimate of how many years you have to work and save until you can live off your interest.

EDIT: There seemed to have been a small mistake in my formula, kindly pointed out to me by Robert. I needed to make the safe withdrawal from the money I have left over each month, after savings. This means that I shouldn't be using income, but rather (income - saved). What does this do for our formula? We don't need as much years to save as initially thought.
I crossed out all the wrong parts and put the correct values in the examples. I also rearranged the formula a little bit, so it's a bit easier to read.

It goes like this:
years = (((income*1/swr*12)-nestegg)/saved)/12
years = (((income-saved)*12/swr)-nestegg)/saved/12

years: number of years you need to work until early retirement
income: monthly income (after tax)
swr: safe withdrawal rate in % per year (if you take this amount from your retirement savings each year, the interest you earn on your invested money should sustain your lifestyle forever)
nestegg: how many you already saved in your retirement account
saved: how much of your paycheck you can save per month

There are other versions of this formula roaming the web, but most of them are just different ways to write the same thing.

The formula in practice

I will show you how the formula works, based on rounded values of my earnings and savings.

Income: 1400 EUR (1992 USD)
SWR: this is typically 4% or for conservative people 3%. I pick 4%
nestegg: 25000 EUR (35575 USD)
What I save each month: 600 EUR (854 USD)
How long do I have to work if I keep saving this much each month?

years = (((1400*1/0.04*12)-25000)/600)/12 = 54.8611
years = (((1400-600)*12/0.04)-25000)/600/12 = 29.8611

This means that after 55 30 years, I'd be financially independent, able to retire without worries. That would be at age 27+55 = 82. That would be at age 27+30 = 57.

A bit to old to my likings. Lets see how we can improve on this...

Retire Early
If you want to retire early, you need to get the result of the formula down. The easiest way to do this is by dividing by a larger saved number.

Pay close attention to this! The more you can save, the earlier you can retire.
This is beautiful, because the one thing we have the most control over is what we spend. By controlling what we spend, we can make the amount we save per month bigger.

So more saving = less working!

Suppose I can save 750 EUR/month (1065 USD).
The result would be:
years = (((1400/0.04*12)-25000)/750)/12 = 43.888
years = (((1400-750)*12/0.04)-25000)/750/12 = 18.8888

150 EUR/month (213 USD) of extra savings gives a difference of 55 - 44 = 11 years!
150 EUR/month (213 USD) of extra savings gives a difference of 30 - 19 = 11 years!

I like it. I like it a lot!

In the spirit of minimalism, I'm gonna keep it at this. It's the most important lesson to be learnt here. Remember the above and start saving, if you want to retire early. The more you save, the better...