Mighty Bargain Hunter

Is retiring by age forty this simple?

June 15th, 2007 | by mbhunter |

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Trent of The Simple Dollar wrote this article that appeared on MoneyCentral:

Retire at 40:  Here’s how

Trent answers a reader’s question regarding how long it would take to retire at current income levels if he saved 20% of his income.  He used the following assumptions:

• Put 20% of each paycheck into an S&P 500 index fund
• Assume 4% annual raise each year
• Assume that the fund “continued to grow at the long-term historical rate (12%)”

Using these assumptions he concludes that his 20-year-old reader could retire at 41 at current income levels, or at 43 with a 4% “raise” each year, off of the interest and dividends in his index fund.

Under these assumptions, this is reasonable.  My calculations saw the interest income exceed current income a little earlier, but I may have implemented the assumptions a little differently.  So I agree with the answer under the stipulated assumptions.

I also applaud the appeals to frugality and investing a big part of the paycheck before the money ever hits your bank account.   These are excellent tips.

The saving by itself isn’t easy to pull off, especially over 20 years, but even assuming he could do that, I probably wouldn’t be telling him to sell his alarm clock on his forty-first birthday.  This investment strategy probably wouldn’t do the trick.

• First, a 12% return for the S&P 500 is on the high side, even historically.  I took all 20-year windows of monthly S&P 500 closing prices since January, 1950, using data from here and calculated the average annual return.  The average price appreciation for any given 20-year window was under 7.3%.  The 20-year sliding appreciation was over 12% for less than 4 years out of the nearly 37 years.   The average dividend yield from the S&P 500 from 1960 on is 3.23%, so the average return (appreciation plus dividends) is a little over 10% (assuming dividends in the 50s weren’t that much greater than 3%). 
• This is the yield before anything is taken out.  Fund expense fees are taken out each year, the dividends and capital gains from exchanges within the fund are taxed each year, and the capital appreciation is taxed when the fund is sold.  Even with the (now) lower long-term capital gains tax rate, this will take a bite out.
• What about inflation?  Unless the withdrawals continue to increase to match inflation, one’s standard of living is going to go down.  The interest income matches the salary at the beginning, but that fixed amount buys less and less as time goes on.
• The guy will be 41!  Didn’t he get married?  Won’t he have kids?  Won’t he have any kids approaching college age?   (Maybe not, but the thought of that isn’t very appealing now that I’m married with a beautiful daughter.)  Unless his kids take on their own debt, each one going to a private school would send him back to his commute unless he was making $100,000 at age 20.  Even if he lives frugally, his biggest expenses will likely be during his forties.

It sure would be nice if that’s all we had to do:  Work at a job, get modest, standard-of-living, “attaboy” type raises each year, tighten the belt for maybe two-thirds of a typical career to put a large chunk each month into VFINX, buy and hold and not touch it for twenty years, and start skimming the money off for the next forty years, never touching the principal because the market magically grows at 12%, blissfully unaware that the next 40 years are going to bear little resemblance to the previous 40, and paying no heed to the wave of baby boomers that have to sell their stock funds because they’re starting to hit that mandatory distribution age of 70 1/2.

Making any assumptions about what you’ll need to retire is a sure way to kill your retirement dreams.  Being able to retire at age 40 requires extraordinary planning, risk-taking, and hard work, likely even before age 20, likely outside of standard employment channels.  The comfort of a steady paycheck by itself — even a decent-sized one — almost certainly won’t lead to this kind of early retirement.  (Even living by oneself:  I’d want to hear the conversation that ensues when the guy tells his wife that he can fund his retirement, but not hers!)

If I were 20 (I’m not) here’s what I’d do to have a chance to be able to retire at 40, knowing what I know now:

• I wouldn’t get any more letters after my name, except maybe CEO.  Advanced degrees in some fields are licenses to hunt for higher-paying jobs, but they take a really long time to get.  I was 28 when I finished school.  I spent nearly all of my twenties at a severe financial handicap.  Not the way to retire quickly.  (Actually, of the half-dozen graduates in my church this year, my bets on the most successful of the bunch were on the guy who was going to go to trade school to be a welder!  That’s going to be a useful skill!)
• I would work to build equity in a business, not to earn a paycheck.  Working for someone else won’t make you rich enough to retire at 40 — unless, perhaps, your bosses’ names are Sergey Brin and Larry Page.
• If I needed a paycheck, I’d work like the dickens after hours to build equity or improve my skill set.
• I’d look beyond the S&P for my investment needs.  It’s hard to make a lot of money buying what everyone else is buying or what everyone else is telling you to buy.  And I almost certainly wouldn’t buy and hold!  The problem with “buy and hold” is that they never really tell you to “sell!”
• I wouldn’t be complacent.  Even a rigorous plan like the one above breeds complacency.  Why just 20%?  Why not as close to 100% as possible? 
• I wouldn’t retire at 40.  I’d be too afraid that I miscalculated somewhere in my predictions about what the year 2034 has in store for me and my investments.  I might look for more meaningful work, but not quit entirely.