Back in 1957, Franco Modigliani, an Italian-American economist and the recipient of the 1985 Nobel Memorial Prize in Economics, strived to explain this behaviour of the population to save during time of high income so as to use the savings after retirement or during period of low income in order to even out the consumption during lifetime, essentially providing an economic framework behind the idea of planning for retirement. Financial planning for retirement is filled with various determinants and considerations, many of which are unforeseen, and most of the time is characterised with worries and dilemmas, which is ironic to the life the planner is hoping to achieve – quiet, peaceful time with friends and family. Getting down to the nitty-gritty of planning for retirement is stressful, and many people do not even bother for it, opting to remain unmindful of the consequence of their decision in the twilight years of their life. However, it can’t be stressed enough that everyone should prepare and plan on how they would expect to live after they retire from their jobs, which demands a series of sacrifices and decisions. Moreover, taking an early retirement brings into fore other essential questions and challenges which we would seek to review.
The first and foremost question for people who are planning to take early retirement is deciding how old they should be when they retire and defining early retirement. These are highly subjective questions which no financial planner or self-help book can answer for an individual. Firstly, you need to figure out precisely what the phrase means to you. Are you seeking to focus only on work in shots and travel in between, or non-income producing hobbies which might not lead to any paychecks, at least not in the short-term? Potential retirees need to understand that unless they want to, retirement, not least early retirement, doesn’t have to mean never earning money again. Everyone can have their own definition, which might range from never having to give priority to work over personal life to leave the lucrative corporate job for something more creative where you can make your hours. So, defining what you mean by retirement is very important, still the goals of individuals can change with age and responsibilities, making them susceptible to various alterations during the planning stage.
Amongst the initial steps in the planning phase is the decision to pick a target age at which you like to enter the retirement phase. To some, retiring early means age 45 while to others, age 60 is the right age, which also can be volatile as post-retirement aim changes and deciding the ideal day-to-day will make it easier to plan. It must be noted that picking a target age or date is imperative for planning for early retirement as a severe impact on the amount of income you may need can be felt even from a five-year difference. Many factors can help you determine what the right figure can be, including lifestyle changes such as new hobbies that may cost more and could make you money, how you will cover the cost of health insurance, the life expectancy and how it affects for how many years you will need retirement income. Many of these are tightly interlinked with what the ideal definition of retirement is for you.
The next important step to determine is the monthly estimated consumption potential retirees are targeting, which would help in determining the targeted corpus at the start of retirement. This is highly correlated with the consumption level and expenses people are incurring at the time of planning. The Life-Cycle Theory of Consumption, which was mentioned at the start, posits that individuals seek to smooth consumption over the course of a lifetime, while the concept of Loss Eversion in behavioural sciences states that the pain of losing is psychologically about twice as powerful as the pleasure of gaining. This suggests that individuals would try to even out their consumption throughout the lifetime and would prefer to save more and cut back on expenses while they are earning, instead settle for a decreased level of consumption after retirement.
There are many thumb-rules which seek to guide individuals on when they should retire and how much they should start saving to build a corpus. However, for most of the people, calculating this can be quite tricky as it involves very complex calculations and ideas, which is best left to a financial planner. Some experts suggest that the value of investments must be enough to enable you to withdraw 4 per cent of the total savings every year. Other suggests that early retirees must strive to save enough to cover expenses in cash for a year plus between 25 and 30 times their expected annual expenses. However, as noted, these can’t be valid for everyone and can vary with different goals, along with any expectation of potential regular or one-time income during retirement.
After deciding and settling on some crucial points, now comes the time when you choose where you would park your money which can ensure the maximisation of your wealth and provide you with regular income. Again, do not hesitate to seek professional help and take the time to do careful research as you cannot afford to make mistakes which can make your plans go awry, as the investments you will now choose need to provide income for your remaining lifetime. Often the best way to optimise your savings is through retirement accounts, and early and frequent savings is one strategy which is present in nearly every story about financial independence and early retirement, indicating the importance of cutting back on unnecessary expenses in the early years to ensure maximisation of income in retirement. As the old aphorism goes: every penny saved is every penny earned.
You also need to consider the asset class you should target which aligns with your goals and risk-taking capacity. Though equity offers attractive returns, they are also high risks assets, which can see your money dwindle in the short term, while providing a decent return in the longer-term. Therefore, early retirees can opt to invest a lower share of their income in equity assets, and instead go for bonds. The return provided by this asset class is pre-determined and offer a relatively safer way to invest. Investors can also go for assets of emerging markets as well, which though is riskier, but provides lucrative returns, especially as the yields in developed countries – including the UK – hover around all-time lows.
Moreover, in addition to ensuring that no unnecessary consumer debt, especially with a high-interest rate, is not taken, individuals should try to pay off their mortgage debt, though that depends on people. While some feel that being mortgage-free certainly adds another level of mental freedom, other reckon that the money saved in interest payments would be lower in comparison to potential investment returns, suggesting that potential return on investments play a crucial role in deciding whether to pay off debts.
If you are planning on taking early retirement, you need to realise that planning for a stress-free and comfortable retirement demands a series of hard-hitting trade-offs, which although might seem unpleasant now, pay big if you are consistent and disciplined. Other than the factors and required decisions mentioned above, there are several other personal and qualitative elements which can impact your choices. This involves whether your plans and your partners are aligned, whether there is a medical risk that runs in your family that might require hefty expenses, how much do you plan on spending on your child’s education, and many more. During the early 2000s, the United States of America saw a massive rise in wealth due to a steep but unsustainable increase in house prices. You should factor in that as well, in addition to your desire to own to, let’s say, buy a house on the beach or a house in the suburbs.
While deciding to retire early might seem a precarious decision, if you are careful enough and have planned meticulously, you might have the best time of your life after you retire and see all the hard work paying off. Always remember that no matter how fool-proof your plan might seem, consider what could go wrong (remember Murphy’s Law), and you always need to have a Plan B, along with ensuring that you have skills at hand which can come to use if things don’t go as planned. Save and plan now to reap benefits in future.