The ABC (and D through J) of Early Retirement

Retirement is too important to not have a comprehensive plan about what to do if – God forbid – something were to go wrong. Here is our Plan A, as well as our Plans B, C, D, all the way through Plan J. Just in case!

We have almost achieved our goal. We have followed our plan meticulously for many years and we could retire today if we wanted, but we like to delay the big day a little further to be more comfortable. Until early 2018.

Giving up your paycheck to live off passive income is a bit frightening. So many uncertainties! One big uncertainty, of course, would be a significant drop in the value of our investments. Dividends can be cut, companies can go completely bust, bonds and loans can go into default. So, there is no certainty that passive income will just keep rolling in at the pace we planned. Before we even get to Plan B, we want to design Plan A that’s robust enough so we hopefully won’t need Plan B and beyond. Start by avoiding to make unrealistic assumption about Plan A:

Plan A, as in “all as planned”

• During our last two working years, save, save, save and then save some more and be frugal. As we show here, with an aggressive savings rate of 60% of net income it should be possible to retire in 10-15 years. Even faster for the more aggressive savers that can up their savings rate to 70-75%. We have reached the point where we could retire now and fund our current expenses at a below 4% withdrawal rate, but it’s always better to have an extra cushion
• Choose a low enough withdrawal rate, at least in the beginning. Certainly no higher than 4%. We target 2.5-3%
• We will continue have most (if not all) of our savings in productive assets that have the potential to yield and even exceed (in real, inflation-adjusted terms) the percentage we intend to withdraw each year: stock index funds, real estate, etc. and we stay away from get rich quick schemes
• Use caution when working with past returns. True, in real terms equities returned about 6.5% for the last 150 or so years and bonds maybe 2%-2.5. But if a 10 year government bond yields 1.7% nominal today (4/8/2016), we don’t see how that that would generate a 2% real return over the next ten years. Likewise with stocks, where we appear close to another business cycle high with currently anemic earnings growth and already rich valuations. In similar situations in the past, a 4% real return was more likely than 7%. Burton “Random Walk Down Wall Street” Malkiel recently made a 6%-6.75% forecast for equity returns going forward. That’s nominal! After inflation, expect 4%-4.75%, so about 2 percentage points below the historical average
• Have a budget that reflects the realities of retirement: no more health insurance through the employer. But there are many savings associated with early retirement as well: move to a less expensive city in a tax friendly state, no more work lunches at $10+ a piece, etc.

In case something still goes wrong, have Plan B, Plan C, …, and all the way to Plan J available:

Plan B, as in “back to work”

• When you plan to retire in your 30s or 40s, it would be insane to assume that you’ll never work another day in your life. So in case of lower passive income, replace some of it with active income!
• A caveat is that it only works if the jobs we can and want to do are in some way recession-proof. If Mr.&Mrs. Early Retirement used to work as a construction worker and mortgage underwriter, respectively, they would have had a hard time going back to their respective fields in 2008/9. Be cognizant of the potential correlation between your earnings potential and the stock market and business cycle.
• Mrs. ERN is trained in nursing. There will always be demand for that line of work and it could be full-time or through a temp work agency. That by itself might not replace all of our passive income but we hope to only supplement a drop in income. We can still live off the dividend income, but use the extra income to avoid selling equities at fire sale prices like in early 2009
• Mr. ERN currently works in finance and could take up some consulting work. But we realize that opportunities for that might dry up if the stock market takes a big enough hit
• The “gig economy” opens up a whole new route. It’s not a matter of if you want to work, but how much. Work as an Uber/Lyft driver for a few hours a week to supplement income if you need. It might be a great way to meet people too. We heard that simply driving for the ride share companies during peak demand times (e.g., New Years Eve) you can make you a fortune.

Plan C, as in “curb consumption”

• We are working on two budgets, one baseline and one with a 25% reduction of expenses
• Certain expenses will have very little wiggle room, at least in the short-term, such as housing and health insurance. Longer-term even they can be changed, because one could move to a cheaper place or health care could become cheaper if income is lower and Obamacare subsidies kick in. But short-term you could be stuck with some very fixed expenses.
• Other expenses have essentially 100% wiggle room. We could decide not to travel as much (or not at all!) for a year. The same is true for all discretionary spending
• In the table below we show our baseline budget per $100 spent and the budget with reduced spending (-25%). This assumes owning a very small home paid for in cash. Most expenses are assumed to be fixed. We reduce utilities and driving by 25% and restaurant meals by 50%. The other discretionary categories are cut by 46.8% to match the budget. Still very manageable, especially if it’s temporary.

Plan D, as in “different location” with lower living expenses

• A while ago, MarketWatch had a nice piece on retirement destinations, see here. Replace the desirable and overpriced retirement locations with their respective cheaper versions in the same state. Get 90% of the benefits for 50% of the cost! Just check here to compare living expenses in different locales
• Your dollar goes a long way in some other countries. Health care is much cheaper abroad, too! Mexico, Panama, Costa Rica, Philippines and Thailand seem very popular with retirees on a budget. You don’t even have to go to a certified low-income (and potentially slightly unsafe) location. Countries like Spain, Portugal, Italy and France routinely make it to the top spots of favorite low budget foreign retirement destinations. Living in rural areas there is extremely cheap because of the lack of jobs. That shouldn’t concern us as retirees; we should even enjoy the slower lifestyle. Great food, relative safety and first-world amenities are also attractive.

Plan E, as in “earn extra money”

• In addition to plan B there are other ways to earn extra income: Rent out a room, either permanently (roommate) or temporary (Airbnb)
• Do a yard sale and get rid of all that stuff that accumulated over the years

Plan F, as in “family” – move in with the in-laws

• This is not for everyone, of course. But for us personally we get along great with Mrs. ERN’s parents. Likewise, Mrs. ERN gets along very well with Mr. ERN’s mom. As a temporary solution, moving in with the parents/in-laws might work for us
• Long-term this would not be very desirable because we don’t want to end up the Dr. Phil show. But in a home with an in-law suite and some separation, why not? Homebuilders now design multi-generational homes where each generation has its own space, see here. That might be a more sustainable long-term solution

Plan G, as in “grief” – what one or both of us die or become incapacitated?

• Among all the things that could go wrong, losing money is not the worst. Losing a spouse is. Be prepared for the unexpected. People die or become incapacitated at very young ages all the time, whether through accidents or illness.
• All our documents are in order. We each have a will, power of attorney and healthcare directive. Signed and notarized. All accounts have designated beneficiaries
• We have a centralized place where we keep the important documents. Scanned versions are stored in PDF format on our computer and on a cloud backup site (carbonite.com).
• The surviving spouse will know what money is where. We left instructions for close relatives in case we are both dead or incapacitated. Part of that package is a list with all account information; account numbers, contact info, instructions etc.
• We prefer our daughter to not become a multi-millionaire at age 18 in case we both find an early demise. We set up a revocable (living) trust to hold our assets. The trust will become irrevocable when we’re gone and will hold the assets until she turns 35

Plan H, as in “harvest” both tax losses and gains

• If during retirement we experience a big market meltdown, we should at least make the best out of it. If any tax lots in a taxable account end up in loss territory, harvest the losses
• In years of economic duress, our income might be low enough that we can fill up the two lowest tax brackets with long-term gains, which are not taxed at all in those brackets. This would increase the cost basis and can save taxes in the future!

Plan I, as in “Increase withdrawal rate”

• This is only recommended if the current withdrawal rate is significantly below 4%, which should be true for us
• After stocks declined and valuation (stock price relative to earnings) got beaten down we wouldn’t feel so bad about upping the withdrawals back to the rule-of-thumb 4%. Right after the crisis is when future expected returns will again be above average

Plan J, as in “Japanese lost decades”

• As bad as the 2008/9 episode was, at least the U.S. market recovered after March 2009 and it did so with a vengeance, easily reaching new all time highs just a few years after the trough. A lot worse than that would have been the Japanese experience, initially called the “Lost Decade” but that decade is now already 27 years long with no end in sight. In 1989, the Nikkei 225 index hit its high at 38,957 points. It hasn’t reached that level since. In 2009 the low was at 7,155, almost 82% below the all time high. Currently, we are under 16,000, still about 60% under the high watermark, see chart below
• To be fair, at the market peak in 1989 the Nikkei was insanely overvalued relative to earnings (50 times trailing earnings). Also, Japan has some other obstacles, like shrinking population etc. that are not present in the U.S.
• But other features of a Japanese malaise are present here too: monetary policy is stuck with very low rates for fear of choking off the little bit of growth we have. Fiscal policy tried to stimulate the economy, created a little bit of temporary growth but nothing lasting. In fact, the only thing lasting is the massive pile of debt that’s now a wet blanket on economic growth
• The solution for Plan J: Currently, we are planning a slightly more generous (not luxurious, just generous) retirement than the folks at “Your Money or Your Life” (paid link) or even Mr. Money Mustache. If the economy and the stock market indeed enter a Japan-like scenario, there is still the potential to massively cut our budget to that of the seriously frugal bloggers. They seem to have a great quality of life and so will we.

Conclusion

That’s it for now. We made it all the way to “J” but if you like, please add your own suggestions for completing  the alphabet in the comments section. Even with all of this planning, who knows what will go wrong. As they say, it’s the bus that you don’t see that will hit and kill you. But the more we plan the more confident we can be about retirement.