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Doug Carey

Financial Independence Retire Early – What To Do In Case Of FIRE

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Financial Independence Retire Early

The all-caps are intentional. FIRE stands for Financial Independence Retire Early, and it qualifies as a small phenomenon after gaining a lot of momentum in recent years. In short, it refers broadly to younger people who save (and invest) an extraordinary percentage of their income for some period of time, and then retire – or “retire,” in quotes.

We use quotes because the “retire” part of the equation is somewhat fungible. Leaving a career is normally part of the equation, and working at anything full time (at least for one person, if it’s a couple) is too. But engaging in gainful employment on the side doing something you enjoy or have an interest in is still fair game.

Financial Independence Retire Early – The Trade-Off

The trade-off here is that, in exchange for sacrificing for a while, you can get out of the rat race (or stop working for “The Man,” or insert your own euphemism for working here) a lot sooner than most people – even in your 30s. This may mean committing (or condemning, some would say) yourself to living frugally for the rest of your life, and foregoing certain expenses or luxuries that others take for granted. But FIRE adherents say that the trade is worth making because of the freedom it affords them – the “independence” part. Financial security opens up new avenues for people interested in trying something new, whether it’s income producing or not, without being afraid of the opportunity cost (and the potential opportunities lost). Most have done the math and figure that if worst comes to worst, they could do something menial part-time and, between that income and a tiny draw-down on their investments, cover all or most of their living expenses.

On The Other Hand

That all sounds great. Living to work is out; working (as much as you need to) to live is in. The cost of consuming without considering what it means to your wealth is a big focus of the movement and something we happen to have written about too.

But we do have some concerns. Here are a few of them.

The next recession. The FIREd seem like a thoughtful bunch. We’ll give them the benefit of the doubt and assume they have considered, and even quantified, what an extended market downturn or an economic recession would do to their plans. All they need to do is be aware that it could happen and then stick to the plan.

That’s a lot easier said than done, though. Great money managers will tell you that until you’ve been through a bear market (or multiple bear markets), you don’t know how you’ll react (or if you’re cut out to be a money manager in the first place). Most of the FIRE crowd had barely reached an age to have even entered the workforce during the last recession, let alone started down the early retirement path. So they don’t really know if they’ll be able to handle the stress of watching the value of their investments drop by 30% or 40%.

To be sure, it’s probably a certain kind of person that undertakes early retirement in the first place. Self-motivated, frugal, flexible, detail oriented. All of these characteristics will help in case of emergency, and all else equal, such people should manage better than most. Even so, looking for work exactly at the time when there’s little work to be had is no fun for anyone.

Financial Independence Retire Early
A severe market downturn can really impact a retirement plan.

Uncertainty about spending for long stretches can be wrenching. A key piece of a lot of traditional retirement plans is scaling back on luxuries or vacations when times get tight. If you go into retirement with your eyes open about the possibility of having to do this (effectively lowering your portfolio withdrawal rate for certain periods), and you’re in your 60s or so, you can make a plan work that otherwise might not.

But that’s a different situation entirely than being, say, 40 years old, with a child or two, and having to cut back. That would be tough enough to prepare for financially; it’s almost impossible to prepare for mentally. It helps to have an awareness of your personality type. Could you ride out such a stretch without losing sleep or becoming a stressed-out wreck?

Past performance is no guarantee of future results. When we talk about planning for the future, we almost invariably start by looking to the past. Stuff like projecting asset class returns, running Monte Carlo simulations, and our bear market simulator (highlighted above) is based on the idea that the past will repeat itself to some degree.

That’s OK, to a point. After all, we have to start somewhere, and over time, the past probably will repeat itself, at least from a 40,000-foot view.

But the particulars can vary. And early retirees need to be looking at those particulars. The Four Percent Rule is a great example. Any 30-or-so-year retirement period should be able to handle a 4% withdrawal rate, it says, no matter the market environment.

Before the early nineties, though, a lot of planners thought it was more like 5%. More recently, as fixed income yields have been stingier, you hear 3% lot more often.

Might the rule change again? If so, it could certainly be unpleasant if you’re halfway through a long retirement and counting on a rule being a rule.

Whatever your withdrawal rate rule is, WealthTrace can help you get it dialed in.

Leading By Example

We make compromises all the time, and maybe early retirement should be no different. Maybe if you hang it up professionally at 35 or 40 and have done the math and are comfortable with your projections, you’ll chalk up not being able to afford, say, traveling in luxury 10 years down the road to one of those compromises. You can’t live in the shadow of what-ifs all your life.

Even if you’re not ready to be that extreme about it, there’s a lot to learn here. Those who have taken the plunge offer insights that most of us can benefit from, whether we’re retiring early or going the more traditional route.

For a lot of us, maybe it’s simply another lens through which to look at something we already know to be true: If we live like we want to retire early by doing all the things we know we should be doing (maxing out the 401(k), watching our spending, and so on), we might actually be able to do so.

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How Low Cost Index Funds Can Affect Your Retirement

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low cost index fundsThis summer Fidelity announced it was launching two exchange traded funds (ETFs) that have no annual cost at all. Most funds charge an annual expense fee to pay for the variety of costs that go into managing a mutual fund or ETF. But Fidelity is using these funds as loss leaders in order to get more people to invest with them.

The two funds are the Fidelity Zero Total Market Index ETF (FZROX) and the Fidelity Zero International Index ETF (FZILX). These are just the beginning. Fidelity has already said they plan on introducing more cost-free funds to consumers soon.

In addition to adding no-cost funds, Fidelity also decided to no longer require any minimum investment to open an account with them.

Index Funds Are Still Your Best Bet

The two funds mentioned above are index funds. This means there is no active management of them except the buying and selling necessary to keep them the same as the index they follow.

Index funds have been proven to be the best way to invest over the long run time and again. Their low fees always end up beating market timers and funds that charge a hefty fee for active management. Actively managed funds also have much higher turnover, which can increase your tax bill and eat up your investments due to more trading fees.

Warren Buffet has said many times that index funds are a person’s best bet when investing. We can’t all be Warren Buffet in terms of picking stocks, so index funds are the way to go for the majority of us.

Fees and Your Retirement

Over a long period of time, even a small reduction in fees can do wonders for your retirement portfolio.

 If you are trying to maximize your wealth at retirement, there are several financial planning tools available today that will show you how big of an impact fees can have.

The changes in an investment portfolio over time due to lower fees is exponential. The savings might start out small, but because those savings are reinvested, the amount grows larger and larger over time.

Let’s look at an example of this. I used WealthTrace to show how a portfolio can change over time as we decrease the fund fees a person is paying.

 

low cost index funds

 

This is a $740,000 portfolio. I reduced the fees paid on fund investments by 0.40%. This saves them over $1,700 per year. More importantly, over several years it saves them nearly $100,000! This is the power of compounding that I mentioned earlier as the savings are reinvested.

At the same time, higher fees mean a lower portfolio balance. I ran the same portfolio with fees that are just 0.20% higher and I found that they would have nearly $45,000 less at the end of their retirement plan.

The difference in fees can make or break a retirement plan. That is why it is a great strategy to seek out low-cost index funds, or even no-cost funds like Fidelity now offers. It can mean an earlier retirement with less stress and more money to spend.

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Taxes In Retirement Can Make a Big Difference

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taxes in retirement

Have you given much thought to where you’ll want to live in retirement? If you’re reading this in February in Minneapolis, you might be giving it a lot of thought. On the other hand, if you live in Phoenix, you may have decided you already have it squared away.

There’s a lot more that goes into the decision-making process than climate, of course. This recent Money magazine piece delves into another aspect: how far your retirement savings will go.

Cost of Living is Important

Cost of Living in the US

It’s no secret that the cost of living will vary from one place to another. If you are at or near retirement age and are planning to move somewhere, you have to have some idea about what the cost of living will be there. A glance at the map above confirms what you probably would guess: Generally speaking, the coasts are expensive (in red), and the south is cheap (in blue).

How Much Do You Really Need for Retirement?

Let’s start with a few of criticisms of the piece.

First, the authors assume 0% returns on retirees’ portfolios after retirement. While this may sound conservative, it’s simply not realistic – and anyway would be unacceptable for a lot of potential retirees if it were. It also assumes no change at all in the cost of living over time, which isn’t generally how this works. Last, within one state’s borders, the cost of living could vary widely. It’s expensive to live in New York City, but what about out in the countryside of New York state? You can’t really tell here.

But you have to start somewhere in deciding on where to live in retirement. Is the house too big for us? Is the winter too cold to deal with at our age? Where should we go? And of course the cost of living will be a part of those conversations.

Housing, Healthcare, and Taxes

In this article, the biggest components of cost of living are housing and healthcare. Another potential biggie is state taxes. If you move to Florida or one of six other states that don’t charge state income taxes, you might really notice a difference – especially if you’re coming from a place where the marginal tax rate is more like 9% or 10% on the high end.

If you think you’ll be earning a lot of taxable income in retirement, those marginal rates (and the base rates too, probably) are going to matter. But having a good estimate of your spending as well as your income in retirement should be a big part of your calculus when you’re looking at switching states. This is because states generally need to make up for that lack of (or low) income tax somehow, and one obvious place to do that is other types of taxes, such as sales taxes. If you’re going to be spending a lot on living expenses in retirement, those sales taxes might be a bigger factor than the state income tax.

Consider Income Tax

As the map in the image above indicates, a million dollars in one state is not the same as a million dollars in another. Along the same lines, high taxes on one person may not be high taxes on another.

Moving to a state with no income taxes will not automatically reduce your income tax bill. As with so many things investment and finance related, the answer to whether it might help you is “it depends.” (And we haven’t even touched on property taxes here, which can also make a huge difference, just as they do before retirement.)

Running The Numbers

Using WealthTrace, we can take a look at what a lower tax rate could mean for a plan (and you can create an online retirement plan yourself).

In our example, a relatively well-off couple is hoping to retire in about a year. They are 59 years old and have $7 million in invested assets. Their estimated annual living expenses are expected to be in the $225,000 range.

The couple lives in a state with a fairly high average income tax rate of 7% (that average accounts for their marginal rates, which go up as income goes up). Assuming they stay put, the WealthTrace Monte Carlo simulations says they have an 81% chance of a successful retirement plan.

But they could do better. If they were to move to a state with no income taxes, things look materially better.

What’s happening here? At its core, reducing taxes means reducing spending. Any drop in outflows, whether on taxes or anything else, will give a retirement plan that much more chance of succeeding.

One Piece Of The Puzzle

As we mention above, taxes – and the cost of living in general – are just one thing to consider. Another factor, for example, that could be a topic for a whole different article: the availability of quality health care. Moving where the cost of living is low may not do you a lot of good if you can’t find good doctors.

When putting together your retirement location priority list, be sure taxes are on it alongside health care, climate, and whatever else is important to you.

What other expenses have you considered in your retirement plan? Share with us in the comments below!

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Average Retirement Savings Are Not Enough But There’s Hope

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average retirement savings

Although economic growth and incomes are up over the past year, average retirement savings are worse than ever. A recent study that analyzed savings data shows that the typical American household is woefully unprepared for retirement.

At first glance, the average retirement savings for American households looks reasonable at over $160,000. However, the median tells a much different story. The average value is skewed much higher by the ultra-wealthy. By using the median value, we can see how the typical household is doing. It’s not pretty.

median household average retirement savings

The median value for the average retirement savings in American households is only $11,700. This means that half of these households have saved less than this amount.

Save Early, Often, And To A Tax-Deferred Retirement Account

You may have heard it before, but the key to having enough money in retirement is to start saving as early as possible. But most people have no idea how much they need to save in order to retire when they want. Some even think they can retire early, but have never run any numbers to confirm that this is possible.

There is also the problem that many Americans are not even saving to a tax-deferred retirement account. This is costing some people thousands of dollars over time and can completely change their retirement picture.

The Numbers Might Surprise You

Not so sure? Here’s how important it is to save to a tax-deferred retirement account early and often.

I used the WealthTrace Retirement Planner to look at a case study. I set up a plan for a couple that is 32 years old and saves $4,000 per year, all to taxable accounts which have a current balance of $8,000. Their asset allocation is 75% in stocks and 25% in long-term bonds. They want to retire when they are 67. Their projected annual spending in retirement is $58,000.

I generated a retirement plan for this couple and saw that they are projected to run out of money by age 75. This is a serious problem for them and it means they are not doing enough to shore up their retirement.

Numbers showing the average retirement savings is not enough.

Why Average Retirement Savings Run Out Of Money

This couple is in serious trouble and there are three main reasons why.

One issue is that they are only saving to their taxable accounts and not to a tax-deferred retirement account. If we switch their savings over to an IRA, they won’t run out of money until they are 88. This is just how important tax-deferred retirement vehicles can be.

This couple should also be taking more risks given their young age. There is no need for them to be 25% in bonds for retirement. They should be more like 90% in stocks and 10% in bonds. Stocks always outperform bonds over a long enough time horizon, and this couple has 35 years until they retire.

They should also do everything they can to save more money for retirement. I found that if they boost their savings up to just $7,000 per year instead of the $4,000 they currently save, they wouldn’t run out of money until they are 110 years old.

Save For Retirement Every Paycheck

Everybody should be auto-depositing at least some of their paycheck for retirement. That way you don’t even see the money and there is less of a temptation to use it. Saving with discipline is so important over the long run. It also should go without saying that if your company offers a 401(k) plan you should contribute at least up to the maximum amount where your company matches your contribution. These company matches are free money, and you should utilize it as much as possible.

Underfunded Pensions-Be Prepared

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It is becoming more and more clear that that many cities and states will never be able to fulfill their pension promises. Over the past 20 years most states and many cities have been increasing pension benefits. These benefits plus health care for public employees is at an unsustainable pace. This will eventually lead to underfunded pensions.

underfunded pensions

Because of the gigantic hole that many cities and states now have, it is pretty much a certainty that we will see many Detroit-like bankruptcies in the near future.

Underfunded Pensions Deficits Are Massive

The current estimate for how large the pension deficit for cities and states is tops the $5 trillion mark. Incredibly, that is equal to nearly 1/3 of the United States’ annual GDP.

We have seen cities already slash the pension benefits by up to 55%.  As an example, the city of Central Falls, Rhode Island did in 2011. This is probably a worst-case scenario for many cities. Even a 10% hit to pension payments can devastate a retirement plan.

Retirement Planning What-Ifs

Between those of us who worry about our promised Social Security benefits and those who now fear their pensions might be cut, it is difficult to plan for retirement these days. However, we can at least run some what-if scenarios to see how much pain we might be able to handle if our promised benefits don’t come to fruition.

To test out how a typical retirement plan might be impacted by a cut in pensions, I ran some scenarios in the WealthTrace Retirement & Financial Planner. These scenarios can be run by anybody, without the need to hire a financial advisor.

I set up a 57 year old couple that has a retirement age goal of 67. Their Social Security is projected to be $42,000 total each year. The wife has a promised pension of $45,000 per year in retirement. They projected their annual expenses to be $73,000 each year once they retire. Their IRAs have a combined $30,000 in them.

Because of their combined income from Social Security and the pensions, they can cover their expenses fairly easily every year in retirement as you can see below.

underfunded pensions 2
But what if the city that is paying out the pension declares bankruptcy? I ran some what-if scenarios on this situation. The scenario shows where the pension payments are cut by varying amounts. You can see the results below.

underfunded pensions

You can see that as their pension is cut by 20%, their probability of meeting all of their retirement goals begins to drop quickly. This probability is determined by using Monte Carlo analysis.  This analysis which runs 1,000 scenarios on their plan, shifting the rates of return on their investments in every year based on historical data. If their pension is cut by 40%, they are guaranteed to run out of money in retirement.

What Can Be Done?

If you or your spouse are depending on a public pension, you should research the health of your city or state. Are they way underfunded? If so, you might want to run some scenarios on your pension. This will help you to see how much of a hit you can take. It is also best to have a safety buffer built up in an IRA or 401(k) plan. In the sample case I ran, the couple only had $30,000 saved. I found that if they had instead saved $250,000, they could withstand up to a 45% cut in their pension.

Are you receiving a pension? How is it working for you? Please let us know in the comments below.

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What You Should Know About Roth IRA Conversions

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roth ira conversions
There is a lot being written about converting to a Roth IRA these days. With so much money being tied up in IRAs, it is becoming a very important question.

When thinking about converting from a traditional IRA to a Roth IRA, not only do you have to figure out how much to convert, but you also need to think about when and over how long of a time period.

When using a traditional IRA, you contribute your dollars pre-tax, and you will pay taxes only when you withdraw later in retirement. Roth IRAs are a bit different. You cannot deduct the contributions from your taxes, but when you withdraw later on, nothing is taxed.

In general, the goal is to minimize your taxes. But it’s a bit more complex than that. It also depends on the timing of the tax savings.

The Roth IRA vehicle was only created 20 years ago. It is just now starting to become mainstream. Although most people should probably not convert to a Roth IRA, it is worth it for nearly everybody to at least find out if it makes sense for them. The tax savings could be enormous.

Moving Tax Brackets

If you think you will be in a higher tax bracket when you retire, or if you know you will have very lot tax years coming up, you should definitely look into whether or not a Roth conversion makes sense.

One reason many people cite for wanting to convert a traditional IRA to a Roth is the lure of early retirement. Let’s look at a case study. We have a person, John, who wants to retire when he’s 50. The problem here is that John cannot use his IRA money (without a 10% penalty) until he’s 59.5.

roth ira conversions
This is one case where a Roth conversion can be very helpful. Here is what John can do:

  1. Transfer all IRA money to a Roth IRA.
  2. Pay the taxes on the transfer (you will be your marginal income tax rate on this). If possible, pay the taxes out of taxable accounts and not out of the IRA itself.
  3. Wait at least five years and then begin to withdraw from the Roth IRA, tax-free and penalty-free.

This strategy will allow John to begin using his retirement money at age 55 rather than age 59.5 and he won’t pay the 10% penalty.

Now let’s look at running some actual numbers to see when a conversion makes sense.

Running The Numbers

Let’s look at another case study. John and Jane are 54 years old. They plan on retiring next year. They will be start receiving large pensions at age 62 and social security at age 67. Currently their federal tax rate is only 10%, but that will increase dramatically at age 62 when their pensions kick in. This is a perfect example of a couple who should probably do a Roth conversion.

roth ira conversions
With their current plan where they keep their traditional IRA as-is, they only have a 62% chance of never running out of money, according to the WealthTrace Monte Carlo simulator.

But what if they convert their entire $600,000 IRA to a Roth over a seven year period when their tax rate is low? I ran this scenario and it helps them quite a bit. The results are below:

Their probability of never running out of money jumps by 9%. Part of the reason is that their tax burden would decline by nearly 30%, as you see in the table above.

A Roth conversion is not for everybody, but for some it could be a life-saver in retirement.

Photo: CafeCredit.com