Over the past year, I’ve done various podcast episodes about early retirement. I’ve also had numerous guests share their FIRE stories.
But what about the tactical steps for how to FIRE?
Many FIRE blogs talk a bit too high-level and not enough about the mechanics of how to do it, step by step.
So in today’s episode, I share tactics and best practices I’ve observed on how to retire early. With confidence and assurance. With hard numbers and analysis. With a proper weighing of risks and tradeoffs.
If FIRE is a goal for you, then be sure to listen closely for key insights on how to do it effectively.
What you’ll learn:
- How to project your early retirement cash flow needs / expenses with clarity and confidence
- How to project your retirement income cash flows with clarity and confidence to match those expenses
- How to build the investment assets needed to generate that retirement income
- The 4 main type of investment assets for funding early retirement (and their tradeoffs)
- How to withdraw your retirement spending needs while minimizing risk
- How certain life milestones will impact your income and expense projections
- Tax planning in early retirement
What tips from today’s episode do you agree with / not agree with? What questions of yours about FIRE did I not answer? Let me know by leaving a comment.
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Links mentioned in this episode:
- The exact spreadsheet I use to analyze my income, expenses, and net wealth
- How to set your target asset allocation and rebalance your portfolio efficiently (HYW058)
- Download my FREE spreadsheet to track your current vs. target asset allocation
- Retirement withdrawal calculator: How long will your savings last in retirement?
- My 4×4 FIRE framework for creating and protecting wealth (HYW002)
- Schedule a private 1:1 consultation with me
- HYW private Facebook community
Read this episode as a post:
What’s up, everybody? Welcome back to another action-packed episode of the Hack Your Wealth Podcast.
Today, I want to talk a bit about the mechanics of how to FIRE, or retire early.
In the past, I’ve had episodes on particular early retirement topics here and there, and I’ve also had various guests on the podcast to share their FIRE stories.
But I’ve gotten some feedback that it would be helpful to devote an episode to talk about the mechanics of how to FIRE. Logistically, how can one do it step by step?
Before we get into that, though, I also want to share that I have an important announcement about the podcast at the end of today’s episode. I don’t want you to miss that, so be sure to stick around until the end to hear that update. Cool?
As always, I also want to open by inviting you to join the private Hack Your Wealth Facebook group, which you can find by going to hackyourwealth.com/fb.
That’s a private Facebook discussion group, and it’s a way for us to connect, have a dialogue. You can ask questions about financial independence, early retirement, investing, portfolio management, tax strategies, real estate investing, side business income, or anything else related to financial planning that you’re interested in discussing.
I’m in there every day. I try to respond to every question and comment, so come check it out. Join us there: hackyourwealth.com/fb.
So, the reason why I wanted to do an episode about the actual step-by-step mechanics of how to FIRE is because, a while back, one of my subscribers pinged me and asked if I could share some insight on this.
Specifically, they wanted to know how to analyze and come up with a sound FIRE number, and how to build the investment assets in their portfolio that they’ll need to support their early retirement goal.
In other words, how to analyze the size of nest egg you need to “quit the rat race” and retire early, and what kind of investment assets will actually help you get there, to fund your early retirement living expenses.
Specifically, how do you set up an effective process or system for withdrawing the money you need for living expenses, whether it’s annually, quarterly, monthly, or whatever?
And the context behind this subscriber’s question was that a lot of FIRE blogs talk about FIRE economics in too high-level and hand-wavy of a way, without really revealing how their portfolio is actually invested, how the mechanics of their cash flow withdrawals work to fund their day-to-day early retirement living expenses.
Do they make a withdrawal every month, every quarter, or just once a year?
Is there a way one should structure or set up those withdrawals that’s optimal and minimizes things like market risk?
And finally, how should you think about the tax implications when you’re moving money around and making withdrawals?
In today’s episode, I wanted to lay out as transparently as possible, step by step, some of the best practices that I’ve observed in this area.
If you want to retire early, you’ll definitely want to listen closely to today’s episode, because I’m going to be talking through and walking you through some critical insights and mechanics for how to actually do it effectively.
First off, planning and executing an early retirement plan is fundamentally not any different than what you already know about practicing good financial habits. At the core, it’s about estimating how much you will need to spend in retirement for the rest of your life.
Modeling out and projecting that spend over time and taking into account age, family, and life circumstances that you can reasonably anticipate, and essentially coming up with a year-by-year estimate of how much you really think you’ll need to spend for living from the time you retire until the time you die.
Then making sure to factor in a margin of error, a buffer, to cushion any mistakes you might make in your projections and assumptions, in order to come up with your best estimate of how much money you’ll need for the rest of your life.
If you’ve ever done any valuation of companies, this is no different than, say, estimating cash flows of a business into the future, estimating the growth of those cash flows, estimating any CapEx expense spikes that need to be paid for, in order to come up with how much money the company is expected to make over its lifetime.
It’s the same concept. You’re just doing it in reverse. You’re estimating expenses rather than income, estimating the likely projected growth in those expenses, and estimating any CapEx expense spikes.
Which, for individuals, would be things like healthcare needs or childcare expenses, maybe buying a house, whatever. It’s just the big ticket things that you expect you’ll need to spend on during your lifetime.
I recommend doing this in a spreadsheet, just like you would do if you were modeling out an income statement or a cash flow statement of a real business.
Now, where can you get a template of this spreadsheet to help you get started? You can get a really good one right on the homepage of the Hack Your Wealth website.
It’s free to download. It’s the exact expense tracker that I use for my own expense projections.
And if you have used it for a bit of time to track your own expenses, then you’ve actually already got a really good historical set of numbers that you can start from and analyze to make assumptions and projections going forward.
So, definitely download that free template from the website. And I’ll also link to it in the show notes for this episode at hackyourwealth.com/60.
Once you have your expense projections, you then need to do the same type of analysis for your income sources.
You need to look at each asset in your portfolio and forecast how much income it can produce, either through dividends, appreciation, or direct payments over time. Add those income sources up and compare it to the cash flow expenses you projected.
The analysis you’re trying to do here is to determine whether those income sources will be enough to pay for your expenses each year, each month, with a healthy enough margin of error to account for mistakes in your forecasting assumptions.
Once you feel confident that your assets and the income they produce are stable enough to consistently pay for your living expenses, even after factoring in expense spikes and even after factoring in a healthy margin of error for both your expenses and income, then you have met the dictionary definition of financial independence.
You can FIRE. What’s stopping you?
By the way, that doesn’t necessarily mean quitting your job and just going to sit on a beach all day. It just means having the freedom to do what you want with your time for the rest of your life, rather than having to be a wage slave.
So, that’s the high level nuts and bolts. But let’s get into some of the messier details on what makes this expense and income forecasting challenging, and how to overcome that.
Let’s start with the expense side of the equation first.
The expense side of the equation is somewhat more straightforward, in my view, than the income side of the equation, but it does have its challenges.
It’s straightforward in that you know what your expenses are. They’re generally going to be pretty predictable and stable and consistent, with occasional potential spikes in emergency situations, like if you have a medical emergency or a family emergency and you have to loan a family member a lot of money, things like that.
When you estimate your expenses, you shouldn’t just track your current expenses as a wage earner and use that without making any adjustments to make future projections. You should actually take the time to build a pro forma in a spreadsheet to analyze very closely what your expenses will be in a retirement scenario.
The reason is because certain expenses won’t exist anymore in retirement.
The biggest recurring expenses in a budget are almost always going to be housing, food, and transportation. Those are the big three.
And taxes, of course, too. That’s actually usually number one. But taxes is a special item that can be highly optimized.
The actual consumption expenses that you’re going to have are going to be dominated by housing, food, and transportation.
If you’re early retired, will your housing expenses actually stay the same? Think about that honestly for a moment.
They only will if you plan to continue living in the same house or apartment. But what if you move to a smaller house, to a less expensive area, to a different state, or even a different country?
I’m not saying you have to move out of necessity. But if you’re not tied to a job, then location-independent or even nomadic options might open up for you. It just depends on what you value and prioritize and need in your housing accommodations.
If, because of your own desire, you decide to move or at least live in less expensive housing accommodations, then that’s an expense you can legit cut down in your retirement expense projections.
Just the same, if you’re living in inexpensive small town America right now, and you decide you just have to be in New York City as an early retiree, then your expense projections for housing will probably have to increase significantly. And of course, that then has implications for how much you’ll need to have in your nest egg to support that extra expense.
But you get the point. Get real and literal about how your housing costs might change (or not) when you’re early retired compared to when you’re tied down by a job.
Same deal with food expenses. If you’re early retired, you may be able to alter your food expenses.
With a whole bunch of extra time in your schedule now that you don’t have to work, maybe you want to invest more in self-cooking.
It’s cheaper. It’s healthier. It’s pretty fun.
Or with all your extra free time, you might decide to dine out even more, but you do it, say, during the lunch hour when menu prices are typically cheaper, rather than going out to dinner.
On the flipside, if you decide you want to eat out all the time as a retiree, that you’re done with cooking entirely and you just want to live it up, that’s okay too. You just need to budget for it and have the funds to support that lifestyle choice in your portfolio.
But if you’re living abroad in a less expensive country, it might very well be that eating out all the time for every meal actually isn’t that expensive at all.
In fact, in many countries in Eastern Europe and Latin America and Asia, eating out is really cheap if you’re on an American budget. So it might not even be worth cooking at all if you’re residing in those places.
That’s where your choice of where to live also impacts other cost of living line items.
And other expense categories work the same way. So you should look at every expense item you have and honestly ask yourself, “Will I actually need this when I’m early retired?”
For example, when you’re retired, you don’t need to invest in things like work clothes, work shoes, work equipment or supplies.
Depending on where you decide to live in retirement, you may not need to own a car, which will then also save you all the attendant expenses like fuel, maintenance, repairs, insurance.
My point in all this isn’t to say you have to do or not do any of these things. For all I know, you will keep the exact same lifestyle in early retirement as you had before, the exact same expenses. You just have a lot more time.
Or you might make drastic changes in all aspects of your life if you’re not tethered to a job or location.
My only point is that there’s all these ways your expense budget could change once you’re an early retiree.
So it’s worth actually modeling out your new expense budget as a pro forma in a spreadsheet, with appropriate adjustments to the budget you had before retirement, rather than just assuming that your pre-retirement budget is going to exactly continue without any alterations after you retire.
Now, what makes the expense side of the equation challenging in terms of forecasting is the potential big spikes in expenses that can occur.
Here, probably medical emergencies are the biggest cause for concern, certainly for American retirees, because medical costs, especially if you have to get treated in the U.S., can truly be astronomical. They can easily bankrupt you with six- or seven-figure medical bills for serious medical conditions.
Now, this is a real impediment to confident FIRE planning precisely because you don’t know. You don’t know if or when you might encounter a severe medical emergency.
And while you don’t want to miss out on life just worrying all the time, it’s even worse, arguably, to actually get sick all of a sudden and then be staring down the barrel of certain bankruptcy and having your retirement dreams shattered.
I think the answer to solving this, if you’re an American, is, so far, a really imperfect combination of probably Obamacare for catastrophic care, or being covered on a spouse’s health plan who is still working, and then taking advantage of much cheaper healthcare abroad and just paying out of pocket for that, if need be.
The care abroad might not be quite as state of the art or as scientifically advanced perhaps as it is in the U.S. It might be; it might not be. It really depends on where you’re getting treated.
But if it’s a choice between certain bankruptcy that causes you to live a terrible life versus reasonable medical costs that may not be quite as good but still allows you to live reasonably well, then you might be better off just paying out of pocket and getting care abroad.
Also, keep in mind that staying in a job that you dislike just to retain your health insurance doesn’t seem like a good way to live either. The stress and unhappiness from a job that you hate can be just as detrimental to your health.
Even though you may have health insurance, if your daily life is giving you so much stress and unhappiness, it just might not be worth the health insurance to put up with that.
It’s no different than staying in a job that you hate to pay for a humongous house that you wouldn’t otherwise be able to afford, and then having to work constantly around the clock to keep up those mortgage payments. You’re probably not enjoying that house very much anyway in that case.
Likewise, if you have to stay in a job you hate just to keep your health insurance, how much of life are you actually living anyway? That’s the idea.
Finally, I should also say that it’s a specific set of health diseases, all chronic, that actually create the risk of exorbitant bankrupting healthcare costs.
I’m talking things like cancer, diabetes, heart disease. Things where there’s no real cure, only therapies and maintenance drugs and expensive surgeries, and just procedure after procedure, hospitalization after hospitalization, that rack up the costs that eventually will bankrupt you.
But if you’re in this camp, I don’t know how realistic it is to really plan for FIRE if you’re just trying to make it to the next week and the next month in terms of your health situation.
Obviously, it’s different if you already FIREd and then you suddenly got hit with a severe chronic illness like this. In that case, it’s going to either be due to bad genes, bad habits, or bad luck.
Bad genes and bad habits you can do something about. You can get familiar with your family’s medical history to see if certain diseases run frequently in your family.
You can also exercise and take care of your body more. That’s going to be really important for anyone, especially as you get older.
And if you’re retiring early, it’s especially important to exercise regularly to reduce the risk of chronic illness – not just to reduce the financial risk, but also just to enjoy early retirement more.
And since you should have a lot of extra time to do that in early retirement, it shouldn’t be a very big challenge to exercise regularly if you are disciplined about it.
The one case that is hard to do any planning around is bad luck. There’s just not much you can do about the luck of the hand you’re dealt with. By definition, it’s luck.
But you also can’t stop living. The odds are that you aren’t going to suddenly get struck with a mysterious cancer or stroke or something like that. It does happen in rare cases, but not to most people.
And the type of illnesses where this can happen is really very small. Things like heart disease and diabetes, you’re going to have plenty of advanced notice of those coming because your body is going to be showing symptoms in the years leading up to that, especially if you’re doing what you should be doing and getting regular physical checkups and blood tests.
For black swan event type of illnesses, like a mysterious cancer or a stroke, that’s really going to be very rare. If it does happen to you, of course, it sucks.
What you would do in that case is probably move back to the U.S. (if you were abroad and assuming you weren’t a dual citizen of a country that had universal health insurance), and then strategically lower your current income by holding assets or trading into assets that don’t regularly pay out dividends or cash flows.
That would allow you to choose when to recognize income by selling appreciated assets.
And with that sort of synthetic low income that you create for yourself, you would then enroll in Medicaid, which is the government health insurance program for low-income citizens.
Because Medicaid is not based on the assets you own. It’s based on the income you’re earning. And with low income, you could qualify.
It doesn’t matter how much in assets you own. You might be super rich in terms of the assets you own, but as long as your income is low, you can qualify for Medicare. And then that ends up being a lot more affordable in terms of insurance coverage.
I don’t want to overly dwell on this bad luck scenario too much because it’s really going to be very rare. But I do want to address it because, even though it’s very unlikely to happen to you, I can understand why someone might feel worried or anxiety about this if they’re thinking about early retirement.
Because the impact can be so huge. It can bankrupt you if you’re not careful.
But my only point is that, even though it will suck if does happen to you, even then there are still options you have: even if that means going on Medicaid.
And to be sure, Medicaid might not be as good as your private employer health insurance, but it’s better than nothing, and it can still let you live a reasonably good life.
Okay, enough about healthcare. I think you get the idea at the end of the day, which is, do a rigorous pro forma analysis of what your expenses are actually likely going to be in early retirement. Model that out.
And build in enough buffer, enough margin of error, to cushion for unanticipated spikes in expenses and mistakes in your forecasting assumptions.
In terms of how to know how much you should factor in for a margin of error, that’s a very individual specific question. But the best guide for you on this is going to be your own real historical data.
As I said earlier, you should download the expense tracker spreadsheet that I offer for free as a download on my website, and then literally just do a monthly accounting to track your expenses and see where the highs and lows are, and why, what’s driving them.
Or even better yet, before you early retire, at the beginning of each year, try to forecast out what your expenses will be for each of the next, say, five years.
That may feel like a silly exercise, but it will train you, and it will give you practice in learning how to think critically about your budget and expenses, so you can get good at predicting and forecasting them…
Which is the exact thing you’re trying to do for early retirement expense forecasting, as opposed to having your expenses just happen, without any forethought to them.
And then, at the end of each year, look back and compare your actual versus forecasted expenses to see how close you were and where you got it wrong. And then make another projection for the next five years based on those learnings.
You’ll get decently good at this within a few years or less. And keeping and tracking your historical numbers will then also provide you with a solid foundation of statistical data to build out your real pro forma expense forecast for early retirement.
Okay, enough about that, and enough about expenses. Let’s now shift and talk about the income side of the equation.
We just spent a good chunk of time talking about expense forecasting. But let’s talk about income building and forecasting to match those expenses.
First, if you’re wondering how to actually asset-allocate your portfolio, I do encourage you to check out the episode from just a couple of weeks ago on this exact topic. That will give you a good idea of how you should actually construct your portfolio and the different asset classes you should invest in to match your personal investment criteria and your risk profile.
So be sure to check out that episode at hackyourwealth.com/58.
Now, unlike expense forecasting, which you should be able to do pretty accurately, because expenses tend to be fairly fixed and stable, income forecasting can be a bit more difficult.
The tricky part of FIRE planning is accurately estimating how much capital you’re going to need to generate the income you require for your retirement budget and lifestyle, for the expenses that you just spent all that time modeling out earlier.
Those expenses are generally going to be recurring. They’ll occasionally have a big spike, and you’ll likely be adding a buffer or a cushion on top to make sure you have a margin of error in case you made some mistakes in your forecasting assumptions. We just discussed all of this.
What makes this challenging is that your expenses are generally fixed. They’re probably not going to have a lot of flexibility. And they are going to keep recurring month after month, year after year.
But the income from your portfolio might not be that stable or consistent to match it, depending on what you’re invested in.
It could be very volatile. There could be long stretches where there’s no income at all, or where income falls short of what you expected and needed.
The difficulty then lies in the fact that you have to predict what is the rate of return or cash flow that you can count on your investment capital producing.
You have to assess how risky that cash flow is, both in terms of its stability or volatility as well as its longevity.
You also need to assess how much you can reasonably expect those cash flows to grow and how much you can reasonably expect your investment principal to grow.
If you fail to think critically about the risk involved, you may find yourself in a pinch if you’re, say, a decade into early retirement and you realize, with some alarm, that you’ve depleted your portfolio a lot faster than you should have.
Maybe because you had risk assets in your portfolio that lost too much money, or had too much volatility in the early years, and you didn’t properly account for that. And now you’re a decade into retirement, it’s hard to go back to a career that can earn you a lot of money because your skills have probably atrophied.
On the flipside, if you fail to factor in any growth in your investment income and cash flow projections – if you don’t consider how the income produced by your portfolio assets will grow, then you will end up working a lot more years than you needed to.
And there’s nothing wrong with that, of course, especially if you love your job. But if you don’t like your job, the consequence of that just means you have fewer years to enjoy your life in retirement.
But that’s what would happen if you severely underestimated the expected growth and appreciation in your investment principal and investment income.
In other words, it’s not enough to just have a lot of capital. You have to know what to invest it in. That’s the asset allocation part.
And then you have be able to carefully estimate how much income you can expect each of those investments to produce. That’s the rate of return part.
And then you have to additionally estimate how much those investments are likely to grow and appreciate. That’s the growth part.
And it also impacts how much you can expect the income from your investments to grow.
Finally, you have to estimate how much risk and volatility those investments are exposed to, because that’s going to determine how much downside risk of loss you’re exposed to. That’s the risk analysis part.
As I said earlier, the tricky part of FIRE planning is accurately estimating how much capital you’re going to need. Because all three of these factors (the rate of return, growth, and risk) determine that number.
And those three factors are fundamentally determined by your asset allocation, which in turn is heavily influenced by your investment criteria and risk profile.
To use a simple little example, let’s say you had annual spending needs of $100,000. If you were 40 years old now, and you expect to live until 90, then on some very simplistic level, you could say that the amount of capital you need to retire is $100,000 a year times 50 years, which is the number of years between your current age (40) and when you expect to pass away (90).
That’s $5 million total. Just hold $5 million in cash, and you’ll be set for life, right?
The problem with that is it’s a totally crazy number. One, because it takes no inflation into account. And two, because even accounting for inflation, you should be able to produce $100,000 of real income annually for 50 years with far less than $5 million.
But if you don’t factor in rate of return, growth, and risk, then you might actually come up with a nest egg number like that, like $5 million. And that means you’ll likely overestimate the amount of capital you need to retire.
That also means you’ll likely work considerably more years, potentially in a job you dislike, to build up a nest egg that size, assuming you ever get there at all.
That’s why it’s so crucial to have a really clear view on what are the specific assets you’re holding in your retirement portfolio, what kind of income or return you can expect those assets to produce, what their growth potential is over time, and how risky or volatile those assets might be.
Because that will impact your principal appreciation and cash flow stability, since you will have recurring, predictable, and somewhat fixed expenses that you’ll incur each month and you’ll need to draw down from your portfolio to fund those expenses.
Now, you might naturally wonder: is there any way to reduce the risk or volatility of your retirement income sources?
Maybe you’d even be willing to sacrifice some growth upside in return for reducing the uncertainty in your portfolio returns.
Because if you can fairly accurately forecast the cash flow returns from your portfolio while drastically reducing the volatility risk, even if that means sacrificing some growth upside, then that might be worth it.
Because at least you’ll be able to have greater certainty and predictability around exactly how much capital you really need to generate the income required to meet your retirement living expenses. And by extension, you’ll also have greater certainty around exactly when you can finally pull the trigger and early retire.
Well, there’s a few ways you can do this.
Think about the sources of income that may fund your retirement lifestyle. I think there’s basically four major types. The types that you invest most heavily in will determine the return and risk and growth profile of your retirement income stream.
So here are the four types.
First, you have assets whose returns come primarily from appreciation. For example, stock or equity investments that exhibit a lot of appreciation.
If you had bought a ton of Amazon stock at the IPO, or a ton of Netflix, or Google or Apple over the years, then you probably got a ton of appreciation that you can cash in on to fund your retirement, even though those investments didn’t really pay a dividend for most or all of their corporate lifetimes.
A second asset type is the kind whose returns come primarily from dividends or interest payments.
Here, there might still be some principal appreciation. But the primary reason why you’d invest in this asset type, at least as far as retirement investing is concerned, is because you want the income stream produced by the investment.
You want the dividend paid by the company, or you want the coupon paid by the bond or debt instrument, or annuity, or whatever. And you’re willing to sacrifice some appreciation to get that, because dividend or interest paying investments tend to appreciate more slowly, if at all.
The third asset type is the kind whose returns also come primarily from a recurring payment, but they come from a rental payment. And here I’m talking specifically about rental real estate.
The reason why I mention rental real estate as its own asset type is because I view it as pretty different from dividend or interest bearing investments.
And the difference lies in how passive the investment is, how stable the cash flows are, how large the cash flow is relative to the principal, and how volatile the principal value can swing.
Real estate is generally not as passive as dividend or interest paying investments. Landlording is definitely a non-zero amount of work. There’s real legit work involved.
There are also business expenses involved in being a real estate investor that you have to account for in your projections, unlike dividend or interest paying investments which have no ongoing expenses or work that you personally have to bear.
But the upside is that the cash flows from rental real estate are generally very stable and low risk, and they grow in a predictable way.
They certainly won’t grow as quickly as growth stocks or potentially even dividend payouts, but they will be stable and predictable, which is exactly the kind of certainty that gives you confidence for early retirement.
The cash flows from rental real estate also tend to be pretty large compared to dividends and interest payments from stocks and bonds.
A dividend for a blue chip company might yield 2%, or likely even less annually. An interest rate for an investment grade bond issued by the same company might be 2-3%, maybe 3.5% if you’re lucky, in today’s ultra-low interest rate environment.
Whereas rental real estate in a popular investing market like Atlanta or Dallas can generally produce a cap rate of at least 5-6% annually.
That’s significantly richer than relying on a dividend or a coupon payment from stocks and bonds, especially in a world where your safe withdrawal rate is between 3-4%.
That spread between rental real estate and dividend or bond investments could mean the difference for you between being able to confidently early retire now versus having to work additional years.
Lastly, I just want to highlight that real estate assets tend not to swing in value as much or as quickly as publicly traded assets like dividend stocks or interest bearing bonds. And that’s just because the liquidity of real estate is lesser, and the transaction costs are higher compared to stocks and bonds.
But as a result, that makes the value more stable, more reliable, less risky in terms of volatility, which are all good things for early retirees.
The fourth and last asset type that I’ll mention is business income. This is where you start your own business, your own website, or whatever, that you monetize and that you use the profits from to fund your retirement lifestyle.
Obviously, this asset type is very risky, can be quite volatile, and will certainly be very non-passive. It’s going to be extremely active, in fact, at least for a while early on as you’re just getting going.
But if you’re successful and you can overcome the risks, it can also potentially be very high-growth cash flow as you scale and sell to more customers. Higher than any of the other asset types, for sure.
Since it’s very risky, it’s also always in danger of going obsolete, being outcompeted against, being disrupted by a larger company or platform, whatever the case may be. That risk can collapse your revenue and cash flows very quickly if you’re not nimble.
Ultimately, building and scaling a successful business is a lot of work. It takes a lot of labor and energy.
Make no mistake: you’re creating a new job for yourself. This isn’t “sit on the beach” type of retirement. It’s real work.
But maybe it will be work you deeply enjoy, so you don’t mind doing it. And if you build the asset in the right way, and you’re also lucky, it can produce very outsized returns for your portfolio.
So those are the four asset types.
Back to our original question of “Is there any way to reduce risk in your retirement income sources?”
If you want to decrease risk, then what you’re trading off against is basically growth. You should invest more heavily in things like dividend and interest paying stocks and bonds and rental real estate, because then you’re trading appreciation for greater certainty of current income.
If you’re investing in dividend stocks and interest bonds, you should also consider investing broadly, in diversified indexes of those things (that would be my recommendation) that track a range of dividend stocks or a range of investment grade bonds, as opposed to holding individual stocks and bonds.
Sure, you might sacrifice a little bit of yield that way, but it’s safer and less volatility risk.
Also, as I mentioned earlier, dividends and interest payments are truly passive income. You don’t need to do any work to collect them. But they’ll generally produce lower yields compared to real estate where you will have to invest some sweat equity to make it work.
On the other end of the spectrum, if you want to boost growth, then what you have to accept more of in return is risk and volatility. And that means investing less in dividends, interest, and rental real estate, and more in growth stocks or even your own business, while you’re banking on strong appreciation or revenue growth.
And if you want to increase certainty and stability of your cash flow returns, then you’re back in the land of dividends, interest, and rental real estate. That’s what’s going to give you less risk and more stability.
Whereas if you’re looking to increase the size of returns, then you’re back in the land of appreciation and growth stocks or growing your own business.
Hopefully that gives you a good framework for how to think about the tradeoffs of these different vectors.
Bottom line is: think of yourself as running Mission Control, and you really only have three dials that you’re trying to strike an optimum balance between. Those three dials are: the rate of return, the growth of that return, and the riskiness of that return.
Each dial is going to influence the others. And what you’re trying to do is optimize the configuration of the three dials jointly to produce the best cash flow size and stability that you need to fund the retirement budget you modeled out and created earlier.
Getting this right, just as getting your expense forecast right, can get pretty detailed and granular in building out your assumptions and projections. It can also involve a good deal of sensitivity analysis around your various income sources.
So take the time to build out and really think through your forecasts and assumptions.
It’s not only a good exercise in helping you become a better investor, but it will also help you increase your confidence in your FIRE plan, backed by facts and reality.
And that’s super important in making sure that when you do finally pull the trigger to early retire, you’re really doing it for good. You’re not going to have to go back to work ever, unless you want to, and it’s on your terms.
Beyond expense and income forecasting and sensitivity analysis and asset allocation and balancing returns versus growth versus risk, FIRE planning also requires creating a process, a system, to actually fund your annual spending needs. And I’m talking here about the mechanics of how you’ll actually tactically make the withdrawals.
The reason why the tactical mechanics of withdrawal are important is that you want to minimize the risk of being forced to withdraw when your portfolio is already beaten down, for example, because the entire markets are down.
We saw that happen in 2008. We saw it happen in late 2018. We saw it happen again in the spring of 2020 when the coronavirus hit.
What you’re trying to do is avoid having to invade your principal at a time when it’s already depressed due to a broader market downturn.
That’s the worst possible outcome. That’s the most corrosive and damaging type of portfolio erosion. And it’s exactly what you want to avoid.
So, how do we do that? How do we actually minimize that risk while still withdrawing the funds we need to pay for retirement living expenses?
Because it’s not like you can just pause or skip expenses when the markets are down and withdraw only when the market rallies. No.
You’re going to have expenses every day, every month, every year, because you need a place to live and sleep, and you need to eat, and you need to live, every day, every month, every year.
So, how do you reduce that withdrawal risk, and how do you decouple your withdrawals from what is going on in the markets overall?
Well, there’s a few ways, and they essentially match up with the four different asset types we just talked about earlier.
One way is for investors who primarily own growth stocks, where their returns are largely in the form of capital appreciation. For these investors, what you can essentially do is accelerate your withdrawals when the markets are rallying, and scale them back when the markets are tanking.
And the way you would do this is to have multiple years of liquid spending cash on hand at a time.
Let’s say you target to have three years’ worth of liquid spending cash sitting in a bank account. The idea is, if at the end of the year, let’s say, the markets are doing well, or even just normally, then you would withdraw a full year’s worth of spending cash all at once.
You would add that to your pot of liquid spending cash, so that at the beginning of the next year, you now have three years’ worth of spending cash available to you, sitting in your bank account.
So now you’re set for the year. You don’t have to worry about any stock market volatility during the year. And throughout the course of the year, you just spend down one-third of the pot.
And then, at the end of the next year, you assess the state of the markets again. If the markets are doing well, then you top up your bank account by withdrawing another year’s worth of spending cash.
So, at the beginning of the following year, you again have three years’ worth of spending cash sitting in your bank account, which you would draw down one-third of over the course of the year.
But if, at the end of the year, you assess the state of the markets, and things are not going so well, then what you would do instead is you would not withdraw another year’s worth of spending cash, because you don’t want to withdraw when the markets are depressed.
Because then you’re doubly invading your principal: once because you’re withdrawing, and once because the markets are down. (Remember, that’s the most corrosive type of principal invasion because it takes multiple years often to make that back up.)
Instead, what you would do is: skip the withdrawal for that year. And you would spend down another one-third of your pot. So by the end of the following year, you would have spent down two-thirds of your pot now, and have one-third of the pot left.
And at the end of that year, you would do another pulse check on the state of the markets. If the markets had rallied by then, or had made up from their prior dip, you would then withdraw two years’ worth of spending cash all at once to top up your bank account all the way back up to three full years of liquid spending cash.
In other words, you would withdraw for both the current year and the next year at the same time.
However, if the markets were still in the crapper, you still have one “bullet left in the chamber,” so to speak. You can still skip one more year’s worth of withdrawals and spend down the last one-third of your pot over the course of the following year.
And if you did that, then at the end of the following year, you would now have no choice but to withdraw for your next year’s worth of living expenses, regardless of how the markets were doing at that point.
But one saving grace is that if the markets were still not in great shape even at the end of year three, you don’t have to withdraw three years’ worth of spending cash all at once. You don’t have to top up the entire account.
You can just withdraw one year’s worth of cash, or even just six months’ worth. You can incrementally withdraw only what you need as you wait for the markets to recover. You can tailor your withdrawals to the market conditions.
On the flipside, if the markets had fully recovered and were rallying, you could definitely withdraw all three years’ worth of cash to top up your entire account.
The point is you’re always looking for a favorable time to replenish your cash “pipeline.” And by having a three-year cash buffer, in this example, you get some flexibility to choose when to do that: when to do your top up withdrawals.
This is a really nice way to “smooth out” market dips from your withdrawal schedule, by just skipping certain years where the market isn’t doing so hot.
Because when you look at historical stock market performance, it’s actually pretty rare for the market to be down for three to four years in a row. Usually it rallies back to its high water mark within that timeframe.
It’s not a guarantee, of course. Nothing is a guarantee in investing. But it certainly increases the odds in your favor.
Now, there is a downside, of course, to this strategy. And that is, the opportunity cost of holding that much money in cash that isn’t doing anything for you. It’s not working for you because it’s not invested in anything.
So you have inflation risk and opportunity cost risk of potentially losing out on some upside.
Sure, you can park that cash in a super safe liquid asset like treasuries or a treasuries ETF. But whichever way, since the point of this strategy is to hold liquid cash or a cash-like asset, it’s basically not going to yield anything.
So you will have to decide if that’s an acceptable tradeoff in exchange for having more flexibility to time your cash withdrawals according to market conditions.
That’s one way to reduce withdrawal risk and decouple your withdrawals from overall market conditions.
A second way is to invest in and hold large amounts of dividend paying stocks, so much so that you can live entirely on the dividends alone and not touch any of the principal.
In this case, you don’t really have to care about what the markets are doing at all because you’re not directly exposed to them. Whether the stock price of your dividend paying assets is getting hammered generally doesn’t impact the size of the dividend that’s being paid to you each quarter, at least not immediately.
Now, of course, if the stock price is getting hammered for a prolonged period of time, sooner or later, management is probably going to think about cutting or suspending the dividend in order to preserve more cash so that the company can operate defensively.
In other words, the buffer that dividend payments enjoy vis-à-vis broader market conditions isn’t absolute. It’s just attenuated.
But either way, consistent dividend paying companies generally do not take lightly the idea of cutting or suspending their dividends. They know that doing so will cause them to take a hit of confidence from investors, and they definitely don’t want to do that.
That means fairly short-lived periods of market downturns (and by that, I mean a few years) generally won’t impact any dividends you receive. So you don’t really even need to worry about overall market conditions much if you are funding your entire retirement spending budget using dividends alone.
But remember, this strategy only holds true if you really do not have to sell any principal – if you can really fund your entire budget using dividends alone.
If you do have to sell any principal, then this strategy doesn’t work. In that case, you’re probably better off holding multiple years’ worth of liquid cash and topping up your account based on when market conditions are favorable.
A third way to reduce withdrawal risk is to hold enough rental real estate that you can pretty much fund your retirement using rent payments alone. Then you don’t need to care at all about what the overall markets are doing.
This is pretty similar to the pure dividend withdrawal strategy I just mentioned a moment ago.
Real estate tends to be very stable and bond-like. And people have to pay their rent no matter what’s going on in the overall economy. Even when there are big dips in the stock market, rents still have to be paid.
Rent is probably the most defensible and stable type of cash flow against broad market downturns. When people stop paying rent due to market conditions, that’s pretty much the end of the line.
That means the economy and the markets are basically at the apocalypse. It’s exceedingly rare.
Real estate underlying values also tend to be pretty uncorrelated to the overall markets. As I mentioned earlier, because physical real estate is an illiquid asset with high transaction costs, the values tend to be very laggy compared to what the stock market is doing.
Even when the market is whiplashing, real estate values will tend to be very stable, and rental payments even more so.
The tradeoff of relying on rental real estate to fund your retirement, of course, is that you have to tie up a lot of capital in order to make it work.
Again, let’s say you have $100,000 in annual spending needs each year. That’s $8,333 per month.
To bring that much home in take-home pay from rental real estate is probably going to take quite a few doors.
Remember, you’ll have operating expenses with rental real estate. You have to pay for maintenance and repairs. You might have to pay for property management.
You have to pay property taxes as well as income taxes. You might have mortgage interest payments.
Sure, you might be able to deduct those things, and deduct depreciation, to generate book losses while still taking home cash flow. But even so, you’re going to need quite a bit of rental real estate assets to hit those kind of numbers, so you’ll need to have a fair amount of capital invested to get there.
Lastly, you can also reduce withdrawal risk and decouple your withdrawals from overall market performance by funding your retirement expenses from a side hustle or a side business.
A lot of early retirees aren’t just sitting on the beach all day. They’re actually still earning some income, either having switched careers into something they enjoy much more, or doing freelance work or consulting, or running a side business part-time, whatever the case may be.
And if that earns them enough to fund their retirement living expenses, then that may be all they need. Meanwhile, their investment portfolio remains untouched, and it’s just sitting there and growing like a great big rainy day fund.
Even if they don’t earn enough from a side hustle to fund their entire retirement expense budget, if they only earn enough to partially fund it, that can still make a huge difference in how long their retirement portfolio can last.
Think about it: if you need $100,000 in living expenses each year, and it would normally require, say, a $2.5 million portfolio to produce that, if you earn take-home pay of just $30,000 from freelancing or a side hustle each year, then you only need to withdraw $70,000 a year from your portfolio to make up the gap.
But at $70,000, you might only need a $1.75 million portfolio to produce that. That’s $750,000 less than a $2.5 million portfolio. That might equate to retiring years, or even more than a decade earlier, depending on how much you earn in your job.
So don’t discount the power of continuing a side hustle or freelance work that you enjoy, or even working a job that helps you offset some or all of your retirement budget. As long as you enjoy it, then it will be a lot more sustainable.
So those are a few ways you can mitigate the risk of withdrawal from the overall performance of the markets.
But I should also underscore that however you set up your withdrawals, and in fact, however you construct your portfolio, one thing you should probably do is factor in a buffer, a margin of error, when you forecast your income sources, just like you did with expense forecasting.
You should underestimate by a cushion, a margin of error, how much income your assets can realistically produce after taxes.
Because things will happen over time. The markets will dip, or a company you own cuts its dividend, or your rental real estate sits vacant for a couple of months, or your freelancing clients dry up for a little while.
There’s lots of things that can happen, and probably will happen, given enough time. So baking in a margin of error will help factor in these dips.
The way to bake in a margin of error is to just haircut the expected income from each of your income sources according to how risky it is.
It’s no different than the way a mortgage lender will haircut your non-salary income sources, like rental income or dividend income, when they’re calculating your maximum eligible mortgage amount. It’s the same principle.
So we’ve covered expense forecasting, income forecasting. We’ve covered the different asset types that can support your retirement budget, as well as different ways to structure your withdrawals.
A few other issues we should consider are asset location, life milestones, and taxes.
First, asset location.
As you plan out your asset allocation and withdrawal strategy, you should keep in mind how your assets are actually apportioned into taxable, tax-deferred, and tax-free accounts, because this influences how your withdrawals will work before versus after you turn 59 and a half.
If you’re retiring before you turn 59 and a half, then you need to make sure you have enough saved up in your taxable accounts, because that is where your withdrawals are primarily going to come from.
The younger you retire, the more you’ll need saved up in your taxable accounts. Your taxable accounts will have to do most of the heavy lifting to bridge you from your early retirement date until you turn 59 and a half.
If you’re retiring after you turn 59 and a half, then you can use any of your accounts. But even then, there’s a preferred or optimal order in which to withdraw from your accounts, like an optimal order to withdraw from your taxable versus tax-deferred versus tax-free accounts.
I won’t get into the details of that here because I wrote an in-depth blog post on this exact topic a while back, which I’ll link to in today’s show notes. So be sure to check that out if you want to better understand the optimal order you should withdraw funds from when it comes to your taxable versus tax-deferred versus tax-free accounts.
Second thing is milestones.
As you do your income and expense forecasting, be sure to consider how they might change when you hit certain life milestones.
For example, as we just said, when you hit 59 and a half, you can start withdrawing from your retirement accounts penalty-free. So that will impact what kind of income streams are available to you.
Similarly, when you hit roughly 62 all the way through 70, you become eligible for Social Security. And the amount of Social Security you get depends on how early you claimed during those eight years.
That’s an important income source that will become available to you then. And it may influence how you model out your income needs starting from that age.
Also, when you hit 65, you become eligible for Medicare. And that generally provides a lot of peace of mind when it comes to healthcare because Medicare is generally very affordable for most people, and it does a good job of covering most major health conditions.
Also, you might have a pension that kicks in at some point, depending on your work history and prior employers. That can also add another income stream to the mix.
As you get older, you will likely also just become naturally less active as your overall energy level decreases over the years, and you want to spend more time with grandkids or friends and family and just don’t particularly care to live a globetrotting life anymore.
The point here is: there are all these things that could impact your income and expense forecasting, just by virtue of your circumstances changing as you get older.
If you ignore all these milestones and just assume they’re all going to be zero, that’s super conservative and you’ll have a nice buffer, but it will also probably cause you to work many extra years that you didn’t need to, when you could have retired earlier.
Both because you might not need to save as much to retire when you factor in these milestones, and also because when you factor in these milestones, you might actually be able to spend at a higher rate during your younger years in anticipation of having government benefits and subsidies when you’re older.
I’m not saying you have to do that, or that one way is better than the other. I’m just saying that these are all considerations that can significantly impact how big of a nest egg you think you’ll need to comfortably retire as early as possible.
Of course, you always want to have a decent buffer, or margin of error, to offset any mistakes in forecasting assumptions that you’ll inevitably make.
But also keep in mind that if you assume all these milestones are literally zero – and more broadly, if you assume everything that could happen favorably to you is zero, while everything that could go against you is 100% – then you’ll have to pay for that with real additional, irreversible years of extra work, extra grind.
Last thing I want to cover today is taxes.
With all your income forecasts and withdrawal strategies, you will need to remember to factor in taxes you owe.
Capital gains, pre-tax retirement account withdrawals: that’s not your money yet. The government hasn’t taken their bite.
The only account type where you don’t need to worry about taxes at all is your Roth accounts, because those are tax-free forever. Even tax-free accounts like HSAs and 529 plans have withdrawal restrictions tied to them that could cause tax liabilities.
So, just because you think you have enough saved up, and you think you can generate enough income to meet your retirement expenses, along with all the appropriate buffer, you have to make sure you’re analyzing the after-tax net amount, because that’s the true amount of income you can actually use to fund your retirement expenses.
Not the withdrawal amount itself. It’s the after-tax withdrawal amount.
The lion’s share of taxes here is certainly going to be at the federal level. But depending on which state you live in, there can also be state taxes as well.
This might potentially be a reason to redomicile in a tax-free state when you retire and you’re no longer tethered to a physical location due to a job. It’s one reason why states like Florida are so popular with retirees.
When it comes to taxes, keep in mind that in the U.S., you can actually earn six figures, mostly from investment withdrawals, and pay zero taxes on it, at least under the current capital gains and qualified dividends tax regime.
Everyone gets at least the standard deduction tax-free. And if you live a majority of the year abroad, you can also take advantage of the foreign earned income exclusion.
But remember, that only applies to earned income, not passive income or investment income.
That’s probably more relevant if you’re actually earning an income, such as through freelance work or consulting or a side hustle.
So, we’ve covered a ton of material today. The thing I want to underscore is that coming up with a rock solid FIRE plan, at the end of the day, is about getting crystal clarity on what your cash flow needs are (that’s your projected expenses) and then factoring in an appropriate margin of error.
Then, building the investment assets to produce the income you need to fund those projected expenses, also with an appropriate margin of error factored in on that side. That’s really the key.
Now, there are about four different asset types that can help fund your retirement budget, and they each have different tradeoffs when it comes to rate of return, risk, and growth characteristics.
There’s also a few different strategies we talked about when it comes to the actual mechanics of structuring your withdrawals to minimize withdrawal risk.
Finally, you should keep in mind the factors around where your assets are apportioned in terms of taxable, pre-tax, and tax-free accounts, as well as life milestones and how they might impact your income and expense projections, and finally, taxes and how taxes will have to factor into your income projections and withdrawal strategy.
Again, I urge you to go to the Hack Your Wealth website, or the show notes link to this episode to download my free expenses tracker spreadsheet template that can help you model out your projected expenses.
It’s one of the more useful free spreadsheet tools I offer on the website, so definitely be sure to check that out on the homepage or by going to hackyourwealth.com/60.
Also, I want to give a quick mention that if you have any questions about FIRE planning, expense or income forecasting, portfolio construction and design, asset allocation, withdrawal strategy, tax strategy – any of the topics we covered today – and you would like to consult with me about it, feel free to reach out via my website.
I do offer personal financial planning consultations on an hourly basis. I’d be happy to help you with advice on any of these topics in a way that’s personalized and tailored to your individual situation, so that you can come away from the consultation with a concrete plan and set of forecasts and portfolio strategy, etc.
You can get more info about that at hackyourwealth.com/private-session. Feel free to check that out, and I hope that will help those of you who may still have questions about this.
Lastly, as I promised at the beginning of today’s episode, I want to share an announcement about the podcast as we look into next year.
This will be my last episode of the podcast for the year. I’m planning to take about a month break. Need to recharge!
And when the podcast returns next year, it’s going to shift in frequency to generally once every two weeks rather than every week.
This is something I’ve been thinking about for a while after analyzing feedback and listener statistics, and also just the pace of production to make the podcast sustainable longer term.
Since I don’t really have the resources for a production team for the podcast, moving to a biweekly episode schedule will help me keep the podcast going in a more effective and sustainable way.
If I was able to just work on the podcast full time, then it would be a different story. But since this show gets produced mostly on “nights and weekends,” a biweekly cadence is going to allow me to keep delivering valuable content to you in a more focused and sustainable way.
So that’s the announcement. I hope you stay tuned in when we come back next year.
We have a big lineup of new and valuable content and topics that will make for an action-packed year, I promise you that. So stay tuned!
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