$400,000 Enough?

Is $500,000 Enough for A 50 Year Old?

Many similar situations are discussed in Chapters 1,2,3,4, and 10 of How To Retire Early and Live Well Without Being A Millionaire. To order a copy click here.

J.J. James quit work three years ago at age 47. After twenty years of 60+ hours a week for three different companies, her only investment asset was $400,000 of company stocks she received over the last five years of work. She had no idea how long she could make it on $400,000 and she did not care. All she knew was that she wanted out. After selling shares to pay her expenses the past three years she has $500,000 in stock. She has yet to experience a year in which her stock's price has declined. She is involved in two volunteer groups, exercises every day, has a host of friends, a good therapist, and regularly attends church services and social functions. Frankly, she does not ever want to go back to work again. Can she make it?

The answer depends on many factors. The formula to determine if she can live well the rest of her life off $500,000 in investments is:

((Total retirement living expenses/$500,000) times 100) plus Inflation equals

Target Investment Return

If the target investment return is reasonable then J.J. will be able to live off her investments.

J.J. must first determine her annual expenses . Since she has already been retired three years, she has a realistic idea what she spends while not working. She also has a realistic idea of what her taxes are while retired. She already has the benefit of paying no social security taxes and being taxed only at low capital gains rates. Still, she must separate living expenses over the last three years from tax expenses as future investment strategies could effect her tax rate.

The company stock has more than doubled in price since J.J. quit work. She suspects this is partially due to a big run up in the stock market and partially because business has been good. J.J. must determine the prospects for the company stock for the next 30 years. She is not in a position to spend her last penny as they lower her into the grave. She is in excellent health and must expect at least 30 more years of life if not 50 due to future medical advances. She will not be in a position to spend any of her capital. For now, she must live on the total return from that capital.

She needs to talk to current employees of the company, competitors, suppliers, customers, and any others directly involved in the company. She must compare their opinions to the industry analysts and investment analysts who follow the company. From these sources, she needs to estimate whether or not this stock can be counted on to provide a total return of at least 10% a year for the next 30 to 50 years. The prospects for the company need to be compared to the prospects for a diversified portfolio of stocks, bonds, real estate, international stocks, and other secure long-term holdings.

J.J. cannot, however, count on having the same expenses for the next 30 to 50 years. General inflation will raise the price of goods and services she consumes. She needs to also look at specific aspects of her life that will cause her expenses to go up faster or slower than the general public's expenses. The biggest factor to look at is housing expense. If she owns her home and intends to stay there for the long haul, she can expect to have smaller expense increases than the general public. But if she rents, she can expect to have larger expense increases. If she were in poor health and did not have good health insurance, she could expect a large rise in expenses.

Other factors can also have a large effect on her ability to live off her assets. If J.J. expected to be married and have a spouse splitting housing expenses she would be in a better position. Social security does not kick in for her for at least 12 years, Medicaid for 15, and it is best if she waits 20 years to take any social security payments. If she expects an inheritance, she should only factor it in if the future grantor is quite ill and has made specific estate plans that include her. It is not unusual for someone perceived to be self-sufficient to be left out of a will while the irresponsible relatives get to continue their dependant ways at the deceased's expense.

J.J.'s research determines that the company is in great shape. Sales and earnings are growing about 10% a year. All the analysts like the stock. Current employees and customers like the companies prospects. But the stock has a P/E ratio of 35 and a Price/Book ratio of 5. J.J.'s former boss who retired two years ago has sold more than 3/4s of his shares. A 67 year old who has played the stock market as a hobby since the 1960s, he tells J.J. that the stock should sell at 20 times earnings or less and a Price to Book closer to 2 than 5. He attributes the stock price gains solely to investor euphoria combined with young analysts rationalizing away excessive stock valuations.

J.J. determines that she has been spending $4,000 a month in living expenses, or $48,000 a year and about $5,000 a year on taxes. She owns a three bedroom condo that she likes and intends to stay in for the foreseeable future. She is in good health. She does have a boyfriend but she does not anticipate shared living expenses with this guy this lifetime. She won't be inheriting anything and won't win the lotto because she does not buy lotto tickets. Based on her best estimate, she thinks consumer price inflation with average 3% over the next 30 years but she will have closer to 2% personal inflation.

Applying the formula, she determines her target investment return:

$53,000/$500,000 times 100 equals 10.6%.

10.6% plus 2% equals a target investment return of 12.6%.

If J.J. can make a steady 12.6% a year from her investments, she can stay retired for good. Will she make it?

Based on the current facts, J.J. will have little chance of making it. The stock she currently owns, despite unanimous analysts recommendations, has little chance of returning better than 12% a year over the next 30 years. To justify its current valuation, sales and earnings would have to grow at better than 20% a year for the next 30 years. Few companies have ever done so. While current momentum may keep the stock price moving up in the near term, a return to reality is likely in next 5 to 10 years. In fact, the stock price could easily drop 50% on one bad quarterly earnings report.

J.J. should follow the example of her ex-boss and immediately begin diversifying her portfolio. She needs to own 3 to 5 non-correlated asset classes. Her first move should be to investigate income producing real estate and foreign and emerging market stocks. Over the next five years she should reduce the company stock to 20% or less of her portfolio. This would allow her to build a portfolio that could reliably produce 10% a year for life. Unfortunately, she needs more than 12.6% over the first 5 years. Selling off company stock will increase her taxes enough to raise her target return to as high as 14% for five years.

Fourteen percent for five years followed by twelve plus percent for 30 years is a very difficult target investment return. The investment strategy necessary to achieve such a return could backfire and result in losses instead of gains. J.J. needs to decide if she wants to go for high returns or settle for a secure but smaller return. To make high returns for a sustained period of time, she will have to be a full time investor. She realizes now that she has spent little time on her investments over the last five years. She readily concedes that the returns she got were pure luck. She is not interested in being a full time investor. She only wants a reasonably secure return on her investments. It is suggested in How To Retire Early that anyone living off investments spend at least 10 hours a week managing their portfolio. This is minimum requirement, even for someone using a money manager, to be reasonably secure in their investment strategy. She is willing to put in up to 10 hours a week on her investment to avoid going back to work full time.

Ten hours a week will only ensure that she has a reasonable shot at making a steady 10% a year. For the next 5 years, she needs 14%. In 12 years she will have the option of receiving social security. In 20 years, she can receive maximum social security benefits. Assuming social security is not drastically reduced, after 12 years J.J. will have a target investment return below 10%. For the next 12 years, J.J. must do one or more of the following:

Reduce her expenses, or
Let go of her inflation savings, or
Create some income to pay part of her expenses.

She should not consider spending capital as that will simply make matters worse in the future. Additionally, watching her capital deplete each year may panic her into accepting another 60 hour a week job.

For the next five years she would have to cut down to $2,500 a month in living expense from $4,000 a month. This would allow her to spend $18,000 less each year and therefore create smaller taxable gains as well. That $18,000 could then be compounded each year in a diversified portfolio of 3 to 5 non-correlated asset classes. J.J. does not feel like she would be happy on reduced expenses. She is not interested in living in a smaller home or curtailing most of her activities. The reason she quit work to begin with was to spend time at home and to have a more meaningful life.

Her inflation adjustment of 2% a year is the equivalent of saving $10,000 per year. While it is wonderful that J.J. is in excellent physical condition, she must be financially prepared for longevity. She cannot take a chance that her money will run out in old age. This can be particularly devastating if she became to feeble to work.

The third option, part-time work, is the most promising. J.J. essentially needs an extra $1,500 a month take home pay. She may be able to find paid work with one of her charitable groups or her Church. That way, she can both be of service and earn income. Or she could work with her therapist or a career counselor to find meaningful part-time work for herself.

Many people can retire early on $500,000. If they have total living expenses excluding taxes of $3,000 a month or less they will have no problem. If their total expenses are higher, but social security or other permanent payments reduce the amount needed from investments to below $3,000 they can easily make it. Or if they are expert, active investors they can make enough to cover higher spending. But J.J. has living expenses of $4,000 a month, is 12 years from social security, and does not want to spend a lot of time on her investments. She may find that a life style of part-time meaningful work and part-time retirement suits her well.

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