You Might Have Dialed the Wrong Number

You’ve read about it a hundred times, the four percent rule. All you need to do to retire early is to learn to live frugally and efficiently and then save up 25 times your annual expenses. Some very clever people have worked out the math using the past market performance and inflation rates to show that if you invest that much money, and have no debt, you can be retired for thirty or more years safely without earning another paycheck. Four percent of course is 4/100 or 1/25 which is how 4% gets you to 25. I would never argue with any of that, it is after all just mathematics, and as a licensed professional engineer math is my friend.

Most of the blog posts I’ve seen using this algorithm are written by people who haven’t saved up 25 times their expenses yet, so they are future looking posts. They do know their current expenses and generally, by budgeting, they do a great job of keeping their expenses on target. There is that occasional “uh oh” when Murphy sucker punches them with a leaking hot water heater or vehicle fender bender. But a surprising number of them make a hugely dangerous assumption when they are crafting their financial plan toward Financial Independence and Retiring Early. They forget about the time value of money.

To be accurate they do not forget about the time value of money altogether, they are using it to project the growth of their investments, but they do not apply the same logic to their future expenses. How dangerous is this omission? The answer is “it depends”. If your plan is a highly accelerated scorched earth campaign like Mr. Money Mustache followed then it probably isn’t going to wreck your plans. But if you are more like me and took a leisurely path toward financial independence then it could be a fatal mistake. Not fatal in that you are going to die, but fatal in that your plan may already be DOA (dead on arrival).

Let’s look at two examples, one is a ten year plan for FIRE and the other is a 30 year plan to retire. I would assume most of us fall somewhere in between these two goals, with me being one of the turtles who worked for the whole 30 years while many of you are gazelles who plan on whipping across the finish line in ten or less years. In both cases lets assume you are kinda sorta lean FIRE oriented and have trimmed your expenses to $40,000 a year which covers a life that you enjoy and find meaning in. Using the 4 % rule you need 25 times that or 25x$40,000 which is a cool $1 Million when you leave the workforce. Now I’m also assuming you don’t earn another penny after you retire and I’m not counting paying any taxes on your investment earnings so I’m not being entirely rigorous, but I can still make my point.

Let’s start both cases on January 1, 2019 so that the gazelles will hit their $1 Million target in January of 2029 and the turtles will plod agonizingly across the finish line in 2049. Obviously the gazelles will have had to have had a much higher savings rate than the turtles but for my purpose it doesn’t really matter how they got there. The thing that matters is they are both millionaires and since they can live on $40,000 which is 4% of their one million dollar portfolio they are both sitting pretty, right? No! They aren’t. There is a huge difference in the lifestyles they will be able to afford and I can show you why.

We love to show the magic of compound interest in building a portfolio, if the stock market averages 6% growth you can expect your money to double every 12 years. That is the only way that normal people could ever accumulate a million dollars, because their money compounds over time. What we often do not consider is that the time value of money also works against us when it comes to inflation. While inflation has been very low in recent years that isn’t always the case, in fact during my working career I remember seeing several years where inflation topped ten percent and in 1980 it averaged 13.1%! Nobody knows the future inflation rate but most people use somewhere in the 2 to 3% range per year when they correct for inflation’s impact on the future. I’ll use 2.5% in looking at the impact on my turtles and gazelles because that’s right in the middle.

I’m sure you can see where I’m going with this and the numbers are very straight forward. If you have shown you can live comfortably on $40,000 in 2019 and have accumulated your million dollar nest egg by 2029 then you can pull $40,000 and live just like you live now, right? Wrong again! Because that $40,000 that you withdraw in 2029 is not worth $40,000 of 2019 buying power. When you time adjust it to today’s money it is only worth $31,250. So you can only buy that much food, rent, electricity, gasoline, cell phone, lattes and streaming services. That means cutting your budget by nearly 1/4th of what you planned on spending. I don’t know about you but cutting my budget by 1/4th would really crimp my lifestyle. And that is the result on the gazelles who are retiring in only ten years. If you are a turtle the impact of inflation on the real value of your financial target is much worse. For a turtle that $40,000 in 2029 dollars will only buy what $19,000 buys today. You are losing over half of your buying power! If that is not fatal to your plans it has to at least put them in intensive care.

What’s a turtle to do? Or a gazelle for that matter? The answer is not fun but it is also not complicated. If you are a turtle you’ve got to hit two million at retirement in order to live like you live now on $40,000 a year. Instead of 25 times your current expenses you’ll need to save 50 times. If you are a gazelle it isn’t quite so bad, but you’ll still need to have about $1.3 Million invested to provide you a lifestyle equivalent to $40,000 today. That’s the same thing as saving 32 times current expenses.

That’s pretty depressing in one way but it is not really as bad as it seems. For one thing income also rises over time. If you are making $80k and saving half of it now chances are that you’ll be making over $100k in ten years so if you manage to keep on saving half you’ll be saving more money each year and getting to the $1.3 Million will not “feel” any worse than your original path to saving one million. Same thing for a turtle, in thirty years if your pay just keeps up with inflation, and it should do better than that, then your $80k income should increase to over $160k. You may say “You don’t know my boss and my company, not gonna happen!” But while I don’t know your circumstances I do know my own past. I started work when $18K was considered a high salary (dinosaur, I know) and because those were high inflation years I watched my pay go up to $200k and higher during my career. I also watched starting pay for my 18k job go up to 80k for chemical engineers starting their careers today where I worked. I can personally attest to this inflation stuff being real. I honestly lived just as well when I made $18,000 a year as the new engineers starting now do making $80,000. Maybe I lived even better because of the way tax bracket creep works.

So what does it mean to you? Just one thing. When you figure out your financial independence number you need to know what year you will plan to get there and adjust that for inflation. There are all kinds of free time value of money and inflation calculators on the internet and they will all give you the right answer. Or you can just track your expenses every year, a very good idea anyway, and as you get within a couple of years of hitting your target amount then inflation stops making enough difference to matter. You’ll just keep adjusting your target as you see your actual spending go up a little almost every year. If you are a gazelle you still need to do this, because who can afford a 25% cut in an already frugal budget but if you are a turtle on a 30 year path to financial independence it is even more important. Nobody can afford to cut their spending in half for the rest of their life and feel like they’ve won the prize.

One thing that occurred to me while writing this is that because some people neglect to include inflation in their personal finance planning they set themselves up for budgeting failure. If you have a goal to live on $40,000 in 2019 and you make it, great! But in 2020 your goal should be somewhere in the $40,800 to $41,000 range, it should not stay at $40,000. Sure maybe you’ll ratchet down your spending enough to hold the line but your lifestyle will dwindle because that 2020 money just isn’t worth what it was in 2019 and to live the same life you’ll have to spend more. Once you’ve figured out what the optimum amount is for your life you cannot freeze that number, it has to grow with inflation or your quality of life will suffer. And if you aren’t having fun you’ll never finish the race.

As always, if you want to leave a comment click on the title of the post.

What about you, have you factored in inflation into your financial independence target?

Do you give yourself a little extra spending space each year, not for lifestyle inflation but to account for real inflation?

23 Replies to “You Might Have Dialed the Wrong Number”

  1. hey steve. i know that you know this but that is partly why cash is king. if you have a good chunk of green i think the level you get in a savings account should come close to the inflation rate every year even if one lags or leads the other a little. i surely agree that you can’t plan on a static spending level and that’s good advice. in the late 80’s a track coach of mine told me on a bus ride (he was a part-time financial adviser) that i would probably make million bucks in salary in my lifetime. it sounded like a lot of money but i think he was right. inflation is real, but he might have counted on me being a little higher achiever too.

    1. Thanks Freddy, eventually they will have to retire the word “millionaire” because having a million will be like having $100K is now. But right now its still a chunk of cash for sure.

  2. The 4% rule has come under fire recently, especially with people retiring earlier (sometimes not by choice!). That said, historically the 4% rule would have been enough to overcome average inflation b/c the long-term returns for the stock market averaged 8%. Unfortunately, that’s not necessarily the case going forward, and with value investors like Warren Buffett saying that 6% is a more reasonable return, then the 4% rule would be too high a withdrawal rate. Ideally, you don’t just use a rule of thumb but look at your own individual circumstances and what the markets are doing at the time you retire, and plan accordingly.

    1. Good advice, There are so many variables in play plus the future is always unknown. Japan’s stock market hasn’t seen good growth in a long time, that could happen here too I would guess.

  3. I’ve always been a tad skeptical of the math that shows immediately getting to 25x expenses and then retiring right away. It all just seems a bit too simplistic.

    I recently built a budget model out until we are 95 years old. I just used the cost categories we have now and grew each by different inflation rates (healthcare getting the largest annual increase). Pretty amazing to see that in 50 plus years from now, our expenses could be well over $400k annually. Fortunately, with modest increases in our investment portfolio, I was able to show that we don’t run out of money. I felt much better doing that then just assuming that whatever X times expenses we had in investments would work.

    Dragon Guy

    1. I’d say you’ve done an awesome job of future proofing your plan. Plus you are the kind of active thinker who will revise your plan as you go.

  4. Good post, illuminating a topic many have forgotten. I’ve been thinking about this a lot lately. Sam from Financial Samurai keeps saying something like, “$1,000,000 in the 90’s is more like $3,000,000 today.” In other words, being a ‘millionaire’ in 2019 doesn’t hold as much weight, mostly because of inflation.

    My only caveat is that not all things are inflating in price equally. Generally speaking, the cost of goods has gone down, while the cost of services has gone up. (American) labor intensive products such as healthcare and education are more expensive, but many of the things an early retiree would spend money on have actually gotten cheaper over time.

    1. That’s a great point. Like dragonsonfire by applying different inflation rates to different categories of spending, you have a more accurate way to project retirement spending

  5. Great warning here. I tend to agree. That’s why I preach spreadsheets all day long. You need to model this stuff out and catch all the “gotchas” – inflation being a BIGGY.

    You might want to change the turtle date to 2049 in paragraph 7. I had to scratch my head a little even though I knew exactly where you were going with that.

    I also think it’s okay to factor inflation into your projected investment growth – no need to double ding your time value of money against the money itself and your ongoing expenses. (Call me out though if you think I’m missing the plot?!?)

    1. Oops! There goes my math cred. You always do a great job with spreadsheets cubert. I think you are right on. You could account for inflation in investment growth but most people seem to just calculate the future value of their portfolio without estimating inflation adiusted future spending. You, I know, do it with more rigour that almost anyone else.

  6. One way to combat inflation is to invest in assets whose cash flow moves up with inflation. This is one of the reasons why I like real estate investments so much. Rental income, over time, should keep pace with inflation (or increase at a higher rate than inflation). If you invest in rental properties, then your cash flow should adjust with inflation.

    The other consideration in addition to inflation is income taxes. Obviously, $40,000 a year in investment income is not the same as $40,000 of net cash because of income taxes. Be mindful of this as well when you are planning out your retirement number.

    1. I totally agree. I ignored taxes because I was trying to keep the concept as simple as possible but you absolutely cannot ignore them in your planning. About 1/2 of my portfolio is taxable and 1/2 is not.

  7. Inflation and taxes are the known unknowns and can be accounted for, but not worth the effort to build into my cash flow and budget sheets. I strive to keep my sheets easier to manage. Modeling them may help on annual bases.

    Life is what happens to you when you are busy making other plans. The “Murphy Gotchas” will show up in one form or another and can deflate the $40K figure rather quickly in a one year window. In my case, furnace, water heater and sump pump needed to replaced with months of each other. The furnace was a complete surprise despite being 15 years old. (I thought I could get another 3 years out of it.)
    The trusty emergency fund took care of it and didn’t make an impact except for a big red bold font negative figure on my monthly & quarterly cash flow sheets.

    The point is a 20% emergency cash fund above your annual run rate expenses can work. As one ages up past 50+ years old, the medical “Murphy Gotchas” are lurking.

    1. I couldn’t agree more, as a sixty plus athlete every single tennis match is an adventure in survival as are extreme hikes and mountain scrambles. I think having some “extra” factored in is a very smart strategy because there is not much chance you’ll spend less than you plan but there are plenty of unplanned events that might be right around the next corner.

  8. I agree that young people really need to think about their numbers more carefully. However, the 30 years case doesn’t make sense to me. Who would figure out their FI target and leave it alone for 30 years? Everybody serious about early retirement would evaluate it every year. Or at least a year or two before they retire. The target number will be updated to reflect inflation at that point.

    1. I think you are right in that it is self correcting, except in compounding the early years are the most valuable. If you save for a lower amount than you’ll need after inflation eats into it that will become apparent years before you get there but if you start out with the right number you’ll save more early and will not be behind the ball the whole way.

  9. Very interesting post. I had thought that the original Trinity study had looked at the effects of inflation as part of their conclusions. As pointed out above, the trinity study had a different economic environment where stock returns were much higher than what is predicted for the future (who knows if these predictions are accurate anyway).

    Personally, I am more conservative and don’t use the 4% rule. I actually am closer to the 3-3.5% SWR range, the lower the better for built in margins of safety.

    My planned retirement yearly amount I want has a lot of discretionary money built in (shooting for $125k/yr). Having no mortgage/debt I know if all hell broke lose, I could make due with even $50-60k withdrawal indefinitely.

    1. You are like me in being conservative, which I’d recommend especially for high earners. It’s the lean fires with very little margin that most need to consider inflation when setting their targets.

    1. That is correct, but if you use today’s expenses to set your target that is a decade or more in the future you’ll be way low if you don’t account for inflation between now and your fire date. Once you retire the Trinity study adjusted the 4% for inflation each year after that. But you have to do that manually to generate the amount of savings you’ll need.

      1. Great point. True. The trinity study is based on retiring now with those numbers. But planning for future you are correct that would need more. Thanks for the clarification

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