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By Maria Weyman, creditcardGenius
Special to the Financial Independence Hub
Retirement, whether near or far, is a pretty big milestone in a person’s life.
We start saving for it as early as possible and put as much towards it as we can in order to be better prepared.
Whether we want to spend it travelling, immersing ourselves in our favourite hobbies, or spending some quality time with loved ones, most of us look forward to our retirement but don’t see it happening in the near future.
The average age of retirement in Canada is 64 years old, but the popularized FIRE movement – which stands for “Financial Independence, Retire Early” – is the lifestyle concept that proposes an alternative scenario.
By living as frugally as possible and saving every bit possible while maximizing income and revenue, FIRE-devotees plan on retiring much earlier than the Canadian average.
Although we all want to retire early, and being financially independent enough to retire at a young age is possible, it might not be attainable for everyone.
We can all dream, but it’s important to look at the concept without those rose-colored, heart-shaped glasses we all get when thinking about early retirement. Realistically, the FIRE movement can be quite extreme.
Reasonable income
Living from paycheque to paycheque is still the sad reality for many Canadians, some not even being able to set aside money for normal retirement. Living as frugally as possible is just a means of survival rather than a means to a bigger end.
Stagnant wages and the ever-increasing cost of living has made it harder than ever to be financially stable, let alone financially independent, especially for lower or middle-income brackets.
Not to mention getting higher-income jobs in the first place requires many years of education and consequently entails large amounts of student loans, which in itself can take decades to pay off.
Investment risks
Even if you have an income that allows some wiggle room, saving alone probably isn’t enough. To be successful in the FIRE movement requires some savvy investing.
And since we’re taking away the option of long-term, stable, compounded interest savings, the timeframe is much shorter.
But with higher rewards usually come higher risks.
It’s up to you to decide if the risk is worth the potential payout.
Retirement timeframe
Another glitch in the FIRE movement lifestyle is retirement timeframe: how long you’ll actually be retired for.
Savings breakdown
Let’s crunch some numbers just to get a general idea. The most complicated part of this calculation is compounding interest. Thankfully, we can summarize the effects of compound interest using a multiplier.
Let’s say you’re 23 years old and you plan on retiring early at 40 years old. The average life expectancy in Canada is 82 years old, meaning your retirement fund will have to be sufficient enough to carry on for over 42 years.
Compound interest allows our savings to “go further” than they otherwise would. If we are looking at a compound interest of 3.5% (moderate yield rate) we can calculate how much further savings would go for a period of 42 years:
Savings Multiplier = (1 + Annual Interest Rate)^42 = 1.035^42
Savings Multiplier = 4.241
Where the “^” indicates an exponential power (that is 2^3 = 2x2x2). This means that over a period of 42 years, your savings will essentially be multiplied by a factor of 4.2, which shows you how powerful a force compounding interest really is.
While it’s nice that our savings can grow exponentially with compound interest, taking money out of our savings results in losses that grow with compound interest. As such, if we take money out of our savings at the beginning of that 42 year period, that money is also multiplied by a factor of 4.241. Taking the money out one month after would have a slightly lower multiplier and so on. By summing the total effect of each monthly withdrawal we can also obtain a monthly expense multiplier. The first step is to find the monthly interest rate. This can be obtained as follows:
Monthly Interest Rate = (1+Annual Interest Rate)^(1/12) – 1 = (1+0.035)^(1/12) – 1
Monthly Interest Rate = 0.28708987%
Note that calculating a power x^(1/12) is a 12th root and will require a scientific calculator. After obtaining the monthly interest rate, you need to do a recursive sum representing the multipliers for all monthly withdrawals:
Total Monthly Expense Multiplier = 1st Monthly Compound + 2nd Monthly Compound + … + Last (504th) Monthly Compound
This is most easily done using a loop function available in most programming languages, or even an Excel spreadsheet with 504 rows. The base monthly compounding rate is (1+Monthly Interest Rate) = 1.0028709
Total Monthly Expense Multiplier = 1.0028709 + 1.0028709^2 + … + 1.0028709^504
Total Monthly Expense Multiplier = 1132
Total Annual Expense Multiplier = 94.35
This means our savings (with interest multiplied) must be the equivalent of 1,132 monthly expenses or 94.35 years of expenses. This is a big number (especially for saving for only 42 years) but we must remember that our savings are also growing with interest. To take this into account, we divide this by the savings multiplier, and we get
Retirement Expense Multiplier = Total Annual Expense Multiplier / Savings Multiplier
Retirement Expense Multiplier = 22.25
This means, that with an interest of 3.5% on savings, stretched over 42 years, we need to save up enough to cover expenses for 22 years and 3 months.
Let’s assume you can get by with a living cost of $25,000 per year; it means that at the time we are 40 years old we would require a savings balance of
$25,000 * 22.25 =$556,250 savings by age 40
Now with this interest rate, in order to figure out our monthly savings rate, we would need yet another multiplier. Using the previous monthly compounding rate (1.0028709) over 17 years(204 months)
Monthly Savings Multiplier = 1.0028709 + 1.0028709^2 + … + 1.0028709^204
Monthly Savings Multiplier = 277.6
By building up over 17 years, 204 months’ worth of savings will actually grow to about a 278 month equivalent. Interest helps us a little bit here. This also means that we would need to save $556,250/277.6=$2,003.49 per month or equivalently, $24,041 per year
With $25,000 required for living expenses, this would require a net income of $49,041 per year.
Someone living off $25,000 per year is equivalent to working a full-time 40-hour job with a $12 hourly wage.
The big caveats
The caveat here is that you need to have a consistent 3.5% interest rate compounded over a long period of time: as well as a strict commitment to spending under $25,000 per year for 6 decades (during the 17 years that you’re saving up plus the 42 years that you’re living off of your savings). Keep in mind that the $25,000 for living expenses does not take into account inflation.
Even more important to note is that only the top 20% earners (unattached individuals) make the $49,041 net income required for the 17 years, making the barrier to entry rather high.
The bottom line
The FIRE movement is possible with a few caveats.
But the hard truth is it’s not achievable for most people.
And even if it you’re at the top 20% of earners, it also boils down to just how much you’re willing to sacrifice during the best years of your life – your 20s and 30s – in order to retire early.
Maria Weyman is Co-Founder of creditcardGenius, a purely math-based credit card comparison engine, comparing over 50 features of over 190 Canadian credit cards, so you can maximize your rewards. Rate Your Wallet is a 3-minute quiz that tells you if your card is worth the keep.
