Your retirement number changes based on your investment strategy

Imagine reaching the point in life where your investments generate enough income to cover your expenses, freeing you from the constraints of a traditional job.

The path to getting there can seem daunting. Some people focus on finding the “home run deal” that will suddenly get them there. The reality is that, at least for most people, there isn’t a single investment that will give you the lifestyle you want. Instead, it is a series of investments that combine to generate the freedom you need.

While each investment is important, you need to think beyond the cash flow generated by a single investment – particularly if it you are investing only $50k or $100k at a time – and put each investment in the context of your long term goal.

If you want to replace a high income, you need multiple millions of dollars invested. You need to envision your portfolio with 20, 40, or even 100 investments of $50k-$100k when you are actually ready to live off the cash flow. Of course, you don’t need to save all of that money yourself, compounding helps, but you are still having to invest in enough deals to reach your desired cash flow.

Let’s look at two different approaches to replace your income, to determine how much you will need to have invested on that joyous day when you decide you no longer have to work. This amount is “your number”, how much you need to have before your investments drive the lifestyle you want. While many of you have that number firmly in your mind already, I was surprised at how it varied based on my investment assumptions.

For this example, I am looking to replace an active income of $360k/yr or $30k/month. For some, that is an unimaginable amount, for others, it is less than you are currently earning.

For simplicity, I am making a number of other assumptions:

Inflation is negligible, although you should factor in to an actual plan.
The tax treatment of the income is the same, for potential impacts see [1,2].
You are planning to retire in 20 years.
You will be able to access your retirement accounts as needed.

If your goals are different, adjust the numbers accordingly – the difference in strategies is what is important.

If you were to rely on traditional stock market investing, then a financial advisor (which I am not) would likely suggest that you would need $9M invested in stocks and bonds in order to fund a 30 year retirement. This is based on “the 4% rule” [3] which is the established standard for stock market retirement planning (4% of $9M is $360k). While the market generally returns much more than 4%, this rule allows you to manage the volatility of the market while maintaining your lifestyle.

If you were to obtain the average stock market rate of return of 10%, you would need to put away a little over $157k/yr for each of the next 20 years in order to reach your goal ($9M / (( 1.1^20 -1)/.1)). Given 401(k) contribution limits are only $23k, a couple needs to invest ~$100k every year outside of retirement accounts, get the same 10% return, and allow that to compound for the 20 years. That is investing 43% of your current $360k/yr income, which is a sizeable amount.

Now consider an investment that produces cash flow at 9% over the long term. They aren’t easy to find, but they do exist. At 9% cash flow, you don’t need $9M to replace your income, you only need $4M (9% of $4M is $360k). Assuming you reinvest the cash flow at 9% for the next 20 years, you need to put away ~$78k/yr ($4M / ((1.09^20-1)/0.09)). That is a reasonable 22% investment target.

The difference in the amount you need to save is the difference between living off of cash flow versus having to sell your investment in a volatile market. When you are living off of cash flow, you don’t touch your principal. It just sits there generating the money you need to live off of indefinitely. With the stock market, you need to sell the shares to get money. Since you need to sell at specific times, you can’t wait for a market drop to recover and will have to sell at the lower valuation. Thus the volatility requires you to have significantly more invested than you might expect if you just looked at the overall average returns.

While the amounts invested are very different, in both cases replacing your income requires more than one or two individual investments, it requires a long-term commitment. If you start looking for quick solutions, you are more likely to make high risk investments and fall behind your goals instead of consistently working towards them.

The first step is you need to know what your target number is, which will differ depending on the strategies that you plan to employ. From there, it becomes a numbers game to getting to replace your income from your investments.

We’ll look more at the magic of compounding in the next post.

For additional reading:

This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.