Tuesday, August 20, 2019
Questing for FIRE part 2, or...
Try not to get burned by the markets...
Once you've tabulated your net worth, tracked your monthly outlays, and put into place the reductions in your spending, getting a rough idea of what your monthly expenditures are, you need to see how you'll meet them without a job. This is where the math gets harder but the feeling of deprivation hopefully dissipates. The painful adjustments occur mostly in the beginning, as you develop a system for cutting expenses, learn to relate to money differently, and hopefully begin to see frugality (or at least not wasting money) not only as a painful necessity, but as something to be cultivated as an end unto itself, beneficial to one's well-being, a spiritual exercise in humility if you will. This may be asking too much.
If your spending is mostly within your control, your rate of return is not. You still need an approximation to use in the calculator. As mentioned in my prior post, one of the tenets of FIRE is to take the money you're suddenly not spending and put that cash into Vanguard index funds, preferable VTSAX. All Vanguard funds have very low costs, which is why the FIRE community so often references the company. Anyway, VTSAX fund tracks the S&P 500, which is a good estimation of the entire American stock market. No less an investor than Warren Buffett advocates the same position. Historically, the average rate of return of the S&P 500 is approximately 10%, but that is a gross, not net, value. First, you have fees, which in my case are only 0.30% via TIAA-CREF, and second is inflation, estimated at around 2%. That's the Fed goal anyway. With both of these factors in mind, you can't use the base 10% rate of return to determine your FIRE number or date. On paper, that means I can use a real rate of return of 7.7%. Most people in the community use the more conservative figure of 5%, but I'll use 6% for reasons I'll discuss later. Also, the withdrawal rate is listed at 4%, which gives you a 1% cushion in case of higher inflation or a stock market dip. This is called the safe withdrawal rate, and is an accepted figure in the financial industry. Again, I'll use 5% instead. When the safe withdrawal rate and your spending match, you've reached financial independence; whether or not you stop working is another matter.
The safe withdrawal rate of 4% is actually just a rule of thumb, widely quoted though it may be. It originated in what is now called the Trinity study, which tracked the stock market over an extended period of time, and it does work - almost all of the time for almost all people. It does not, and cannot, account for major drops in the market or sudden unforeseen expenses, like a new roof or huge medical bill. According to the book Playing with FIRE, it works 98% of the time, but that two percent will apply to almost everyone at some point. This uncertainty in one of the reasons why the FIRE community advocates such serious frugality and conservative estimates - both provide a safety net, psychological and financial.
With the rate of return and what I can use for living expenses covered, it's time to use the calculator. I mentioned above that instead of using 5% returns and a 4% withdrawal rate, I can increase both by 1%. This is because I have TIAA-CREF as part of my employment, so I can turn my holdings into a low-cost, high-return annuity, and this step can be taken at any time. The fixed rate of return is 6%, and I can make the change while still adding to the said annuity until I stop working. This will never replace the pension I didn't get, but it does mean I could ostensibly quit tomorrow. That's not going to happen, but I wouldn't be able to access my pension until 60, something I only found out recently. The similar time frame applies to my TIAA fund if I just wanted to take out normal distributions. There's value in that approach, because I could still see gains from the market, potentially indexing my holdings for inflation. On the other hand, the thought of working here until 59 1/2 fills me with dread.
Now that I know my present rate of spending, how much am I making? To truly get a handle on what I can invest, I'll use my after tax income, which is presently $88,000, and the goal is a savings rate of 50%. My income will be more or less stable for the next few years, as our union negotiations are going poorly. I won't include any side gigs, as nothing moves the needle enough to make a difference. I'll make two calculations, one for my present situation, one for when my loans are gone and my spending decreases.
There are a plethora of FIRE calculators online, like the Playing with FIRE version, and we'll try that out at this time. It's useful because it has a mix of investment types and rates of return. It also takes into account your net worth. It does assume you're saving everything beyond your expenses, which isn't possible for me right now. Anyway, my age is 48; my income is listed at 88,000; my net worth is listed at 35,000, and my monthly expenses at $5000. This is what is my situation seems to be right now. After checking my allotment, I'll use the 93% in stocks at 6% returns, 7% in bonds at 2%, and 0% cash at (-3) percent. Some of the stock allotment is actually in REIT's, but I should get 6% regardless. This is very aggressive for someone who is 48, but that's part of the FIRE method. Plug in those numbers and I can retire in only 24 years! Wow, that sucks. It's also wrong. Readers (wait, do I have any?) who are better at financial planning than I, will see the flaws in these numbers: I'm counting the debt twice. I can either count the payments on my debt as part of my expenses, or I can deduct them from my net worth. With that, my net worth is corrected to a net worth of $370000, but my monthly expenses stay the same. Now I can retire in only 15 years. Again, not good, but it's at least better. However, I said flaws, not flaw, so what else is missing? It both way overestimates what I can save towards retirement and ignores what the college contributes. I'm saving $22,000 or so a year, so lets adjust the numbers to reflect what I'm actually investing. Now I can retire in 28 years or 17 years, so the news is even worse than I originally thought.
Because the above scenario is only a snapshot, and I am both actively eliminating debt and cutting spending, I will recalculate using more optimistic figures. The second calculation assumes that I have eliminated the retirement and student loans, and dropped an additional $600 a month in other spending, reducing my monthly expenses to $3578, but increasing my age to 49. I'll increase my net worth by 10% as well, to account for gains in the market and my own contributions, so that will be $407,000. I will also tweak the numbers to include the school's money as well as my own, by increasing my income until I reach a 59% savings rate or a whopping $62,000 per year. If I reach and maintain these numbers, I can retire in only 6 years, at 55. If it's that close to the County's requirement of reaching 55 years old and 25 years of service to officially retire (which occurs in the same year), so I can keep my health care after leaving the school, I'm better off waiting until then. It's actually just as I turn 56, since my anniversary date is in October, and my birthday is in December. Aside from playing with the numbers, where the calculator is most useful is giving me my FIRE number, and at minimum it's $1,100,000, for a monthly payment of $5,500. This would be more than enough, and if I did wait until 56. I could have 1,200,000 for a monthly payment of $6,000. Both are higher than my spend rate, which is great, but I also don't get any more returns on the annuity. This means I'm living on a fixed income, so any money above my spending acts as a hedge against inflation, the value of which cannot be understated.
As instructive, painful, or even fun as crunching these numbers can be, they're only a guide, but hopefully they'll motivate anyone looking to retire before the accepted age of 65, or even older. At minimum the calculator should drive home the point that you have to exercise much greater control over your finances than you may be willing to admit. Completing this step certainly made me aware that I'm not saving anywhere near enough. I already knew that on some level, but my bigger mistake was in overestimating my rate of return. Now I know where I truly stand, and it's a little frightening, which I suppose is a good thing.
I glossed over income a bit, so I'll cover that, what's happening at the job that makes this topic so relevant, and some serious criticisms levied against the FIRE approach in the next post.
Once you've tabulated your net worth, tracked your monthly outlays, and put into place the reductions in your spending, getting a rough idea of what your monthly expenditures are, you need to see how you'll meet them without a job. This is where the math gets harder but the feeling of deprivation hopefully dissipates. The painful adjustments occur mostly in the beginning, as you develop a system for cutting expenses, learn to relate to money differently, and hopefully begin to see frugality (or at least not wasting money) not only as a painful necessity, but as something to be cultivated as an end unto itself, beneficial to one's well-being, a spiritual exercise in humility if you will. This may be asking too much.
If your spending is mostly within your control, your rate of return is not. You still need an approximation to use in the calculator. As mentioned in my prior post, one of the tenets of FIRE is to take the money you're suddenly not spending and put that cash into Vanguard index funds, preferable VTSAX. All Vanguard funds have very low costs, which is why the FIRE community so often references the company. Anyway, VTSAX fund tracks the S&P 500, which is a good estimation of the entire American stock market. No less an investor than Warren Buffett advocates the same position. Historically, the average rate of return of the S&P 500 is approximately 10%, but that is a gross, not net, value. First, you have fees, which in my case are only 0.30% via TIAA-CREF, and second is inflation, estimated at around 2%. That's the Fed goal anyway. With both of these factors in mind, you can't use the base 10% rate of return to determine your FIRE number or date. On paper, that means I can use a real rate of return of 7.7%. Most people in the community use the more conservative figure of 5%, but I'll use 6% for reasons I'll discuss later. Also, the withdrawal rate is listed at 4%, which gives you a 1% cushion in case of higher inflation or a stock market dip. This is called the safe withdrawal rate, and is an accepted figure in the financial industry. Again, I'll use 5% instead. When the safe withdrawal rate and your spending match, you've reached financial independence; whether or not you stop working is another matter.
The safe withdrawal rate of 4% is actually just a rule of thumb, widely quoted though it may be. It originated in what is now called the Trinity study, which tracked the stock market over an extended period of time, and it does work - almost all of the time for almost all people. It does not, and cannot, account for major drops in the market or sudden unforeseen expenses, like a new roof or huge medical bill. According to the book Playing with FIRE, it works 98% of the time, but that two percent will apply to almost everyone at some point. This uncertainty in one of the reasons why the FIRE community advocates such serious frugality and conservative estimates - both provide a safety net, psychological and financial.
With the rate of return and what I can use for living expenses covered, it's time to use the calculator. I mentioned above that instead of using 5% returns and a 4% withdrawal rate, I can increase both by 1%. This is because I have TIAA-CREF as part of my employment, so I can turn my holdings into a low-cost, high-return annuity, and this step can be taken at any time. The fixed rate of return is 6%, and I can make the change while still adding to the said annuity until I stop working. This will never replace the pension I didn't get, but it does mean I could ostensibly quit tomorrow. That's not going to happen, but I wouldn't be able to access my pension until 60, something I only found out recently. The similar time frame applies to my TIAA fund if I just wanted to take out normal distributions. There's value in that approach, because I could still see gains from the market, potentially indexing my holdings for inflation. On the other hand, the thought of working here until 59 1/2 fills me with dread.
Now that I know my present rate of spending, how much am I making? To truly get a handle on what I can invest, I'll use my after tax income, which is presently $88,000, and the goal is a savings rate of 50%. My income will be more or less stable for the next few years, as our union negotiations are going poorly. I won't include any side gigs, as nothing moves the needle enough to make a difference. I'll make two calculations, one for my present situation, one for when my loans are gone and my spending decreases.
There are a plethora of FIRE calculators online, like the Playing with FIRE version, and we'll try that out at this time. It's useful because it has a mix of investment types and rates of return. It also takes into account your net worth. It does assume you're saving everything beyond your expenses, which isn't possible for me right now. Anyway, my age is 48; my income is listed at 88,000; my net worth is listed at 35,000, and my monthly expenses at $5000. This is what is my situation seems to be right now. After checking my allotment, I'll use the 93% in stocks at 6% returns, 7% in bonds at 2%, and 0% cash at (-3) percent. Some of the stock allotment is actually in REIT's, but I should get 6% regardless. This is very aggressive for someone who is 48, but that's part of the FIRE method. Plug in those numbers and I can retire in only 24 years! Wow, that sucks. It's also wrong. Readers (wait, do I have any?) who are better at financial planning than I, will see the flaws in these numbers: I'm counting the debt twice. I can either count the payments on my debt as part of my expenses, or I can deduct them from my net worth. With that, my net worth is corrected to a net worth of $370000, but my monthly expenses stay the same. Now I can retire in only 15 years. Again, not good, but it's at least better. However, I said flaws, not flaw, so what else is missing? It both way overestimates what I can save towards retirement and ignores what the college contributes. I'm saving $22,000 or so a year, so lets adjust the numbers to reflect what I'm actually investing. Now I can retire in 28 years or 17 years, so the news is even worse than I originally thought.
Because the above scenario is only a snapshot, and I am both actively eliminating debt and cutting spending, I will recalculate using more optimistic figures. The second calculation assumes that I have eliminated the retirement and student loans, and dropped an additional $600 a month in other spending, reducing my monthly expenses to $3578, but increasing my age to 49. I'll increase my net worth by 10% as well, to account for gains in the market and my own contributions, so that will be $407,000. I will also tweak the numbers to include the school's money as well as my own, by increasing my income until I reach a 59% savings rate or a whopping $62,000 per year. If I reach and maintain these numbers, I can retire in only 6 years, at 55. If it's that close to the County's requirement of reaching 55 years old and 25 years of service to officially retire (which occurs in the same year), so I can keep my health care after leaving the school, I'm better off waiting until then. It's actually just as I turn 56, since my anniversary date is in October, and my birthday is in December. Aside from playing with the numbers, where the calculator is most useful is giving me my FIRE number, and at minimum it's $1,100,000, for a monthly payment of $5,500. This would be more than enough, and if I did wait until 56. I could have 1,200,000 for a monthly payment of $6,000. Both are higher than my spend rate, which is great, but I also don't get any more returns on the annuity. This means I'm living on a fixed income, so any money above my spending acts as a hedge against inflation, the value of which cannot be understated.
As instructive, painful, or even fun as crunching these numbers can be, they're only a guide, but hopefully they'll motivate anyone looking to retire before the accepted age of 65, or even older. At minimum the calculator should drive home the point that you have to exercise much greater control over your finances than you may be willing to admit. Completing this step certainly made me aware that I'm not saving anywhere near enough. I already knew that on some level, but my bigger mistake was in overestimating my rate of return. Now I know where I truly stand, and it's a little frightening, which I suppose is a good thing.
I glossed over income a bit, so I'll cover that, what's happening at the job that makes this topic so relevant, and some serious criticisms levied against the FIRE approach in the next post.
