FIRE, or Financially Independent, Retired Early is a movement sweeping the personal finance blogasphere. There are teachers on FIRE, Doctors on FIRE, Pharmacists on FIRE, and so on. The idea is to reach financial independence and retire in your forties or even thirties.
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There are two main ways to reach FIRE. The first is to create side jobs and additional income streams until you replace your current income. Many FIRE bloggers plan to keep blogging and raising money from their blogs once they make it big and get enough ad revenue to provide a steady income. They just feel that they’ll do it from a boat or on the beach. The second way is to cut your lifestyle down to nothing so that you can retire with only a modest savings and make it work. This method seems somewhat dangerous since while it might be nice to live in your car in your twenties so that you can save up money, if you want to retire this way it means spending fifty or sixty years living in your car, which could get really old really fast.
Now I’m a big fan of becoming financially independent. In fact, I wrote the book on it. (Check out the SmallIvy Book of Investing: Book1: Investing to Grow Wealthy to learn how to use investing to become financially independent.) But I worry about people trying to retire really, really early. I’m not sure if people really understand what it requires to sustain yourself over an indefinite period without a work income. You don’t only need to have enough of a savings/pile of assets to meet your spending needs today. You also must have enough to allow your assets to grow to keep up with inflation. You’ll also need to pay for medical expenses you’ll see in your forties, fifties, and beyond that you won’t see in your twenties and thirties. The estimate for your out-of-pocket medical expenses once you retire at age 65 today is about $300,000 per person, which will be $600,000 for someone in their thirties now by the time they reach 65. You don’t want to need to come back to work at age 55 after being out-of-work for twenty years.
The fact is that retirement originally wasn’t a long vacation that you would take when you reached a certain age. It was what you did when you could no longer really work since your body was old and frail. Most people were in declining health when they quit work and would pass away within a few years of retiring. Because you would mostly just sit around the house or the spare bedroom, you really only needed to have a little money saved up, or perhaps children who could support you for a little while. This would often occur in one’s sixties, so the retirement age was set at 65 when Social Security and later Medicare were introduced, which then dictated the standard retirement age. The issue is that life expectancies continued to increase from perhaps 67 to 87 and beyond, creating a long period where people we both healthy and active, and therefore both spending money and not working. Now with people wanting to retire when they’ve barely even started their careers and not even reached their high-earning years, it is really critical that people understand what is needed to sustain themselves.
So what is needed to become financially independent to the point where you can retire early?
1. Knowledge of how to generate a steady passive income.
You’ll need a steady passive income stream, which would normally be provided through a set of assets such as mutual funds or rental properties. This portfolio would need to be large enough to pay your expenses each year, which means it would need to generate at least enough income each year to cover your expenses. If you’re generating an income through stocks, bonds, and mutual funds, you’ll need to learn how to invest and create this income stream. A great book for learning all about mutual funds and personal finance is The Bogleheads’ Guide to Investing, which explains how to select mutual funds and maximize your returns. If you’re going to buy a bunch of rentals, you’ll need to learn how to find good rental properties and be a landlord. Start reading up. Good books are The Book on Rental Property Investing: How to Create Wealth and Passive Income Through Smart Buy & Hold Real Estate Investing and Retire on Real Estate: Building Rental Income for a Safe and Secure Retirement.
2. Build up a large enough nest-egg.
Now an investment portfolio is fragile. If you just take a little from it each year, the investments that remain will fill in the gap and it will last indefinitely. If you take too much, however, it will start to decline in value. Once this starts, it is a vicious cycle. You see, the larger the portfolio, the more income it generates each year to replace whatever you take out. When you sell off assets and take money out, however, it reduces the amount of income the portfolio generates. You’ll need to be sure to not take too much from your mutual fund portfolio or you’ll start to see the amount of income produced decline each year, requiring that you sell off more and more assets. This, in turn, means that even less income is generated, so you’ll need to sell even more assets.
It is a lot like what happens when you start paying off debt, where at first the debt balance doesn’t seem to budge since the interest generated just erases any payments you make. But as you start to pay things off, the interest generated each month is less, so more of your payment goes towards paying off debt and the amount you owe starts to decline more rapidly. This then reduces the interest owed, which further accelerates the rate at which your balance drops. The same thing happens when you start selling off assets in a portfolio, except in this case it means you’re getting less income instead of paying less interest.
A set of rental properties will also only generate a certain amount of income. If you are living on rentals and need more money to pay for things because rents aren’t generating enough income, you’ll need to start selling off properties, which will have the same effect as selling off mutual fund shares. Each property you sell will mean less income in your pocket each month, which means eventually you’ll need to sell another property to pay for expenses. You need to make sure the income that you generate is large enough to pay for your expenses. Luckily with rentals the rents will increase with inflation naturally, so they create a natural inflation-hedge. Even better is to have a rental portfolio large enough to also save up and buy more properties with time so that your income will grow faster than inflation and your lifestyle will improve with time. (Are things good enough? Start making bigger donations to causes you care about.)
Calculating how big a portfolio you’ll need.
So how much money can you take out of a stock/bond portfolio? A good rule-of-thumb is that you can take about 4% per year and have the remaining assets both replace the money you are taking and grow the portfolio to keep up with inflation. Taking out 3% would be even safer and is a good idea particularly if you are retiring early since a bad market could otherwise really put you in a difficult position where you have been out of the workforce for twenty years and out of money.
So, if you need $50,000 per year in income, this means that you’ll need between $1M and $1.7 M saved up and invested in stock and bond mutual funds. You would start with $50,000 and then grow your income a little each year to keep up with inflation. Note that with a 3% inflation rate, which has been the average over about the last 100 years in the United States, you’ll be withdrawing about $200,000 per year in forty years. A $1M portfolio would have grown to about $4M, so you would still be withdrawing about 4% per year.
If you’re using rental properties, obviously your income is equal to the rent you’re receiving each month. You can therefore start buying properties as-you-go and plan to retire when the income you’re receiving each month from rental properties is large enough. You can also save up the money you’re getting from rentals while you are still working to have a mega-emergency fund for extra protection. This fund should mostly be invested in stocks since you’ll rarely touch most of it, just dipping in if you have an emergency require a quick infusion of cash. When figuring out your needed monthly income from properties, include an allowance for vacant properties since you won’t have everything rented all of the time. You can base this on trends for your area, which you should be able to learn with a little internet research. Also, budget to be putting money away for maintenance, property taxes, a good umbrella insurance policy, and other gotchas. And again, it is better to have enough coming in to buy more properties over time. Rents will, in general, keep up with inflation, but being able to add properties with time will reduce your risk even more.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.