Before I begin, let me issue a little warning about this post.  What follows is a stream of consciousness type account of some of the things I’ve been thinking about lately regarding calculations for early retirement. I hope that this post generates a discussion rather than provides any answers on its own merits.  I make many assumptions below, but I hope to focus on the method of thinking rather than the merits of those assumptions themselves.  Now that that’s out of the way, let’s proceed:

First, Some Background

A general rule of thumb is that you need 25X your yearly expenses saved/invested to be able to retire.  I’ve discussed this previously in my post, Deciding Early When to Retire.  That number comes from the fact that withdrawing 4% historically allows your investments to last indefinitely.  Assuming the 25X number is correct, you might still be miscalculating your retirement needs.  It’s in this area that my latest calculations come into play.

The two main factors of influence are my mortgage and the fact that retirement investment accounts can’t be accessed until much later in life then I hope to retire.

Assume a 32-1/2 year old with expenses of $6000 a month including a new 30 year mortgage that is $3500.  Using the 25X calculation, you’d say that $1.8 Million is necessary for retirement.   If the inflation-adjusted equivalent was finally achieved in a 401K by age 45, however, retirement still wouldn’t be possible, since that money couldn’t be touched without penalty for many more years.

The Solution

To solve this problem, I’ve been considering retirement in two stages: the first part is from early retirement until full retirement age (or penalty free withdrawal age for the particular investment type) and the second part is from full retirement age onward.

Part One

Assume the person described above wants to retire at age 45 and can’t touch their retirement accounts until age 62-1/2.  Their non-retirement investments will have to cover their expenses for 17-1/2 years.  $6000 x 12 mos x 17.5 years = $1.26 Million in non-retirement accounts.  This number is in today’s dollars.  In 12.5 years, when the person reaches age 45, that number will be $1.823 Million, assuming 3% inflation.  Assuming 11% annual returns, that means they’d need $495K in investments today.  If they have that much, no new investments are required.  If not, then new contributions should be added.  This calculation could be updated regularly to decide the necessary amounts of future investments.  Another assumption here is that investments for part one don’t grow at all during early retirement (or only enough to cover inflation) and will be completely depleted by full retirement age.

Part Two

All other assumptions the same, expenses at full retirement age would be $2500 per month (in today’s dollars) since the mortgage will be paid off by then.  Using the 25X rule, $750K is required.  Adjusting for inflation, the number is $1.82 Million.  But those investments will also be compounding over time, so only $80K is required today.

Other Considerations

Assuming future expenses will only grow with inflation is a general flaw of the 25X rule.  An early retiree may have to find their own health insurance rather than rely on a company sponsored plan.  They may have to pay for their children’s college expenses, weddings, etc, even though those costs aren’t reflected in today’s expenses.  Obviously the other assumptions could also be wrong.

Conclusion

What this two part approach to calculations tells me is two-fold:

First, investing in non-retirement accounts is essential to cover the costs during early retirement.

Second, you may need much less in retirement accounts than you think because a large current expense (mortgage) may not be an expense in retirement and you have a lot of time for retirement account investments to grow before they are needed.

I am very interested to see what other people have to say about this line of thinking.  Again, you may make different assumptions.  The basic idea I’m looking for input on is breaking up retirement calculations into the times before and after retirement accounts will be used for funding and how some of today’s expenses (notably a mortgage) won’t be a factor after full retirement age.