Monday, August 27, 2007

Of Retirement & Dwarves

A few weeks ago I came across this interesting website on Get Rich Slowly. The website offers a tool for calculating your cross-over point: the point at which the income from from your investments exceeds the amount of money you spend on a monthly basis. Theoretically, from that point forward you are financially independent and would no longer be required to work to maintain your living standard.

I found the notion intriguing and played around with the numbers a little bit. Here is what I came up with: assuming we spend 80% of what we make (which is pretty close to the mark), achieve a return on our invested capital of 8% per year, inflation averages at a rate of 3% per year and we gain a pay increase of 4% per year, my wife and I will be achieving our cross over point in... wait for it... 12 years. Financial freedom, here we come! Or, maybe not so fast.

Here's the rub. While the crossover theory is sound in principle, it fails to take into account a number of parameters:

1. Inflation - say we were to get to our cross-over point and then stop working. At that point our income from investment would equal our expenses and we would no longer be adding to our savings, nor would we, in theory, be diminishing them. However, inflation is a nasty beast. Just because we stop saving and investing, doesn't mean that prices will remain fixed. In fact to the two eternal truths (death and taxes) we should probably add a third: inflation. With time inflation would erode the purchasing power of our investment income, and back to work we go (with very few hi-hoes).

2. Market Fluctuations - while our portfolio can reasonably be expected to return 8% annually over the long term, there are no guarantees that we will not be hitting any short term bear markets. Assume we stop working at our crossover point, and the very next year the market tanks and goes does 20%. If at that point we continue to draw down our investment income at the previous rate, the value of our portfolio will erode very quickly. Once again if you listen carefully, you can hear seven dwarves singing a much too cheerful song in the background.

3. Additional Expenses - if indeed we reach our crossover point in 12 years and choose to retire, we will be many years away from qualifying for medicare. Right now our medical insurance costs are largely covered by our employers, but if we need to pay for medical insurance ourselves, that crossover point is probably a little bit farther into the future. Will someone shut-up those darn dwarves already?

4. Asset Allocation - while we are young, both working and have no immediate need of our retirement assets, we can reasonably expect our investments to yield something like 8% a year on average. However, as the time comes for drawing down on those assets to support our living expenses, a more conservative investment strategy will probably be required, and the more conservative your investment the lower the average return you can expect. Once again, our crossover point just got a bit farther away.

So, is there no hope? On the contrary, there's big hope. As we close in on the cross-over point, we will have amassed a substantial asset base, and this asset base will be compounding at a pretty impressive rate. We may not be able to wave our bosses good-bye quite yet, but we will be well on our way and with just a few more years of hard work we will be able to kiss the corporate life good-bye.

Interestingly, I actually enjoy my work and as of today I am not in a rush to leave it behind me. Still, it would be nice to know that the option is there, if I choose to use it.

For a detailed discussion of the cross-over concept, be sure to visit The Simple Dollar.

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