My motivation and mission:
Google sheet that contains list of all WCD lessons and links to all content:
Lesson reviewing how to use Google sheet:
Recap of Lesson 004 - Retirement
In Lesson 004 we explored several different frameworks on retirement. I argued that the normal framework for retirement (E.G. work until 65 then “retire” and live off social security) is simplistic and doesn’t accurately capture the life progression that someone should aim for.
I laid out my framework on retirement. Effectively, there are 3 financial phases in life which I call “The 3 Phases of Capital.” In addition, there are 2 “retirements” in life. These retirements are the transitions between the 3 phases.
The 3 Phases of Capital
Capital Accumulation
Capital Appreciation
Capital Distribution
The 2 Retirements in Life
Active Retirement (Occurs gradually between phase 1 and 2)
Passive Retirement (Occurs gradually between phase 2 and 3)
Lesson 005 - When Should I “Actively Retire”?
Lesson 004 was purely philosophical. Lesson 005 will be much more practical (but definitely still philosophical). I will review several methods to help you determine when you should “Actively Retire”.
Let’s start with a simple example.
Bob
Has $1,000,000 of capital.
Invests his capital into the S&P500 (assuming the average ROI is 10% per year). This is 100% passive and takes just minutes per month.
Spends 40-hours per week working and has a fixed $100k per year salary.
Joe
Has $1,000,000 of capital.
Invests his capital into rental properties and cash flowing businesses like laundromats and car washes. (assuming his average ROI is 15% per year)
Spends 40-hours per week managing his portfolio of businesses and researching new potential investment opportunities.
Would you rather be Bob or Joe? Let’s explore this question….
Exploration 1 - “Year 1 Calculation”
The super easy calculation you could perform is this:
Capital Increase in Year 1 = Income + Capital * ROI%
Bob Capital Increase = $100,000 + $1,000,000 * 10% = $200,000
Joe Capital Increase = $0 + $1,000,000 * 15% = $150,000
Using this method, you might prefer to be Bob. However, this method is flawed for several reasons:
It only looks at one year. Joe can re-invest his capital in year 2 and all future years.
It ignores things like taxes and expenses.
Exploration 2 - Future Value Calculation
The correct way to make this decision is to do a “Future Value” calculation such as the ones below. These calculations uses the principals taught in Lesson 001.
You will see that Bob is the initial winner, but in year 10 Joe takes the lead and then significantly outperforms Bob.
This future value calculation has some assumptions:
Bob is taxed 25% on his income.
Bob and Joe both have $50,000 in expenses per year.
Bob invests 100% of his after-tax & after-expenses into S&P500 (at 10% ROI)
Joe re-invests 100% of his capital each year.
Joe’s income stays fixed at $100k per year.
S&P500 maintains 10% ROI each year (actually not a terrible assumption).
Joe is able to maintain a 15% ROI each year (this is probably the largest and most impactful assumption).
I’m sure at least one person is thinking, “well what if Bob gets raises each year?” Well, even if Bob gets a 5% raise each year, Joe still wins in the end, but it does take him longer to overcome Joe.
Note that Bob’s and Joe’s expenses both changed as I was using 50% of Bob’s income as the expenses for both of them.
What if our assumption of Joe’s ROI was wrong? Let’s look at a scenario that is the same as the previous scenario except Joe’s ROI is 12% instead of 15%.
In this scenario, Bob is the clear winner. Only a 3% difference in ROI drastically changed the outcome. Joe’s final future value went from $35MM to $11MM. This demonstrates how powerful the impact ROI can be and it also demonstrates how impactful your assumptions can be when making these types of calculations.
One small tweak in an assumption can completely change the story. If you are entering the stage of “Active Retirement” I definitely caution you to proceed carefully and gradually. Leaving a good paying profession for active investing can seem great, but there is a possibility that you under perform the passive investment opportunities. (In which case, you would have done much better financially generating income).
How Much $ Do You Need To Actively Retire?
Rule of Thumb
As you will see in the proceeding sections, it’s very difficult to calculate an exact number, but I have a rule of thumb for when you should be considering “Active Retirement”.
Effectively, if your income is less than 5% of your accumulated capital, then it’s time to seriously consider “Active Retirement.”
Example:
You have $2,000,000 of capital
Your income is $100,000 per year.
$100,000 is 5% of $2,000,000.
The sentiment behind this rule of thumb is that you should consider pursuing more meaningful or impactful things in life because your income is now relatively negligible in size to your overall capital portfolio.
It’s Hard to Calculate It Exactly - Too Much Uncertainty
As you can see from the above future value calculations, there are a lot of variables that determine the answer to this question.
Future income from working
Future career advancement
Passive ROI of capital (e.g. putting your money in the stock market)
Active ROI of capital (e.g. spending time researching specific investments and spending time and money executing these investments)
The above variables have a lot of uncertainty. As such, it’s difficult to determine an exact number when you should “Actively Retire”. This is why I have stressed that the transitions between “The 3 Phases of Capital” are gradual and the phases have substantial overlap.
Some Other Important Considerations
Maybe you really enjoy what you do and want to continue doing it. By no means am I advocating for you to quit your job if you really enjoy it.
Maybe you don’t have the desire, knowledge, or ability to outperform the passive investment opportunities like the stock market index funds. If you don’t believe you can outperform the passive investments, then it doesn’t make much sense to stop working to pursue these alternative investments or businesses.
If the two bullets above apply to you, you can still follow my framework for “Active Retirement”. The difference is that instead of your time and energy transitioning into actively investing your capital, your time and energy can transition into your family, hobbies, or other things you are passionate about.
My personal lens for “Active Retirement” is primarily financial. I believe I am approaching a point in life when I could make more money by focusing my time on alternative investment opportunities or starting my own businesses.
For those that are less money-centric, “Active Retirement” is when you reach a point in life when the marginal dollar of income is not worth the life-sacrifice you have to make for that marginal dollar. This is obviously something that you cannot calculate because you can’t put a number on life experiences; it is a very personal decision that will be different for every individual.
Summary
I would say there are two key concepts of “Active Retirement”:
First concept is that the more capital you acquire, the more valuable your time becomes and the less valuable your income becomes.
Second concept is that “Active Retirement” is not a single point in time. It is a gradual transition where you can work less and use your time in more meaningful ways to you.
Eventually you will reach a point in life where you would prefer to use your time for something else other than generating income. This time could be spent pursuing active investments, hobbies, passions, or simply spent with your friends and family. “Active Retirement” is the point in life where you start tapering back your normal job or profession in order to focus this time on other activities that are more important to you.
As we have explored the concept of “Active Retirement” in more detail, we have learned that it’s complicated. Calculating an exact amount of money you need to “Actively Retire” is difficult if not impossible.
It is difficult for money-centric people to determine this number because there is a lot of uncertainty that goes into Future Value calculations. Changing your assumption of ROI by just a few percentage points makes a tremendous difference.
It is impossible for non-money-centric people to make this calculation because they are comparing apples to oranges. Effectively, you can’t compare money to life experiences.
In Lesson 006, we will continue the retirement journey and explore the calculations behind “Passive Retirement”. I promise these calculations are straight forward and much less squishy than “Active Retirement.”
Reference Material & Social Media
In Lesson 030 I cover how to navigate and utilize the Google Sheet I have built for all WCD lessons. This Google Sheet contains a worksheet for each WCD lesson. Each sheet has all of the Excel calculations, tables, graphs, and charts that I have posted in the respective WCD lesson. Additionally, the Google Sheet has a master “Index” worksheet that has links to all of the content associated with each lesson.
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