7 Steps to Quantifying Your Retirement

If you missed my last article, the takeaway lesson is that Financial Freedom (AKA how much you need to retire) is really expensive (in the neighborhood of $2-$3 million…for the average American)!

A number of you were rather shocked to read that and naturally reached out to ask “How to calculate my own Financial Freedom number” and more importantly, “How much do I need to invest monthly to reach that Financial Freedom number”.

So, backed by popular demand, here is a step-by-step breakdown on how to calculate both.

WARNING: This is a ROUGH estimation and shouldn’t be taken as direct financial advice. Rather, this is meant to give you a general idea on how much you need financially to retire and how much you need to invest monthly to get there.

Step 1 – Create a (crude) investment budget

You may not be surprised to hear this – but creating a monthly budget is the absolute minimum that you need when trying to achieve Financial Freedom. At the end of the day, if you don’t know much you CAN save on a monthly basis, how DO you expect to plan for retirement that is decades away?!

Now, I know some of you are sweating nervously when you hear the word “budget” - but rest assured, this is a rather quick and painless experience.

Matter of fact, here is the formula and the 3 components to a monthly budget:

(A)  Revenue – (B) Expenses – (C) Tax Reserves = How much you can invest monthly*

 *Assuming you already have an emergency fund and not in credit card debt.

 Action Item: Start with a simple Google Doc spreadsheet and break it down into 3 parts.

Since this is just a quick exercise, you don’t need to get each line item down to its last penny. Matter of fact, I recommend rounding everything to its closest $10!

(A)  Action Item: Break down your monthly “Revenue”

There are 2 types of Revenues: “Fixed Revenue” and “Variable Revenue”.

You can think of “Fixed Revenue” as your salary or rental income (if you own real estate).

You can think of your “Variable Revenue” as your sales commissions, Uber, babysitting or any income that changes month-to-month.

Due to the uneven nature of this type of revenue, I’d recommend to err on the side of caution and be conservative with your estimations.

(B)   Action Item: Break down your monthly “Expense”

There are 2 types of Expenses: “Fixed Expense” & “Variable Expense”.

You can think of your “Fixed Expenses” like your monthly rent, car payments, student loans, etc.

You can think of your “Variable Expenses” as your “going-out” or “shopping” expenses. Similar to “Variable Revenue”, err on the side of caution and be aggressive with your estimations.

By the end of this exercise, if you find that you are short of your Financial Freedom goal, you can make the most immediate impact by looking at your “Variable Expenses” line items and start cutting there.

(C)   Action Item: Estimate Your Taxes

When creating a budget, most people forget to set aside some money each month to pay their government (oh joy)!

Of course, everyone has different tax situations (and thus can vary widely from person to person). However, in my experience as a Financial Coach, I have found the following website does a decent job in estimate your tax liabilities at the end of the year: https://smartasset.com/taxes/income-taxes

Simply input your financial situation and it will spit a yearly tax estimate. Divide this number by 12 and add it back to the "Expense" side of your Google Doc spreadsheet.

Step 2 – Guess WHEN and WHERE you are most likely to retire

I know. Its wayyyy too early to think about retirement (much less WHERE to retire at)!

But just for the sake of this exercise, go wild and project your dream retirement location. If you are currently reading this and freezing your butt off in the Midwest, I wouldn’t blame you if your “dream” retirement location is somewhere like San Diego (my hometown) ??

As for WHEN you are going to retire, if you have no clue, just assume 67 (the age when full Social Security benefits kick in for millennials).

Step 3 – Finding out how much “Cost of Living” is in your current city

Recently there is an interesting report that found that 65% of Americans believe they are smarter than average (which clearly goes against the very definition of “average”).

With that same logic, it’s easy to see how most people think that their spending habits are less than their neighbors.

Well, it’s time to find out.

Action Items: Go to https://www.numbeo.com/cost-of-living/ and type in your current city.

a)     Look for the line item called “Single Person Monthly Costs” in the Summary section. Write down that amount.

b)     Scroll down and look for the line item called “Rent Per Month” in the summary section. Write down that the amount that corresponds to your current situation.

c)      Add these 2 numbers together to get the “Cost of Living” for the average person in your city.

For example, I was recently living in Ho Chi Minh City in Vietnam. The average "Cost of Living" was a total of $900. $430 was the "Single Person Monthly Costs" and $470 was the "Rent Per Month" because I lived in a 1 bedroom apartment located in the City Centre.

Step 4 – Calculate your “Lifestyle Factor” by comparing your spending habits to that of the “average” person in your current city

Here comes the moment of truth.

Action Item: Take your monthly expense number (from Step 1) and divide it by the “Cost of Living” for the average person in your city (from Step 3).

If you are above 100%, that means you have spending habits that are greater than that the average person in your city.

For example, while I was in Ho Chi Minh City, I was“only” spending $1,500/month. Even though that is a farcry from my usual monthly costs back in California, I am still spending 1.67 times more than the average person living in Saigon.

Side note: If you have the ability to work remote, you MUST take advantage of traveling abroad and living cheaply…you will end up spending LESS money and having WAY more fun.  

Step 5 – Calculate how much you will need to retire to cover Cost of Living

If you want to retire early, not only will your retirement account need to last longer but also you need to be more aggressive with both your savings and investing.

Action Item: Repeat Step 4 but for your dream retirement city and calculate “Cost of Living” for the average person in that city.

Multiple that number by BOTH the # of years you are looking to retire AND your Lifestyle Factor. 

Step 6 - Project it forward with a 2% inflation target. THIS IS YOUR FINANCIAL FREEDOM NUMBER!

Note that up to this point, all the numbers you are coming up with are “present day” numbers.

The reason why this is important is due to inflation, the general increase in prices for goods and services over time. If you have no idea what I am talking about, the best example I can think of is buying a can of Coca-Cola.

Back in 1950, a can of coke literally cost a nickel.

Today?

$1.50 (a 30X increase in price ).

Action Item: Go to https://www.moneychimp.com/calculator/compound_interest_calculator.htm and input your following information:

Current Principle: Input your “Financial Freedom” number from Step 5 here.

Annual Addition: To keep things simple, put “0” here.

Years to Grow: How many years you plan to work for. If you are currently 25 years old and want to retire at 65, you would put “40” in this section.

Interest Rate: Assuming a modest 2% inflation rate, put “2” here.

Hit “Calculate” to get the “Future Value”.

Congratulations! The “Future Value” is the amount you need to cover your retirement in your dream city! THIS is your Financial Freedom number (write this number down).

Now before we move on to the last step, take the time to really let this number seep in.

Was it more than you anticipated? Are you worried that you will never get there?

Don’t panic. Carry on to the last step.

Step 7 – Figure out how much you need to invest monthly to reach your Financial Freedom number!

This is where you can play around with the numbers to see how much you need to invest on a monthly basis! The goal here is to figure out how much “Annual Addition” you will need to match your Financial Freedom number (from Step 6).

Here are your inputs:

Current Principle: This is how much you already have set aside through your various savings and investment accounts.

Annual Addition: This is how much you plan to set aside each year (you can include 401K contributions here). Make an educated guess on how much you should set aside annually.

Years to Grow: This should be the same as Step 6.

Interest Rate: This is the hardest input because no one can anticipate future returns. A reasonable and conservative number is anywhere between 6%-8%. For the sake of simplicity, let’s assume a mid-point at 7%.

Hit “Calculate” to get the “Future Value”.

If the “Future Value” is BELOW your Financial Future number (step 6), then adjust your “Annual Addition” number UP.

If the “Future Value” is ABOVE your Financial Future number (step 6), then adjust your “Annual Addition” number DOWN.

For example, if your Financial Freedom number is $3.0 Million and you are currently a 25 year old looking to retire in 40 years with a current savings of $10,000, you would only need to invest ~$13,000 annually to reach your goal (again, assuming a 7% interest rate).

Not as bad as you thought huh?

But wait! Try playing around with the numbers a bit.

What happens if you wait just 1 year to invest? In other words, assuming everything is held constant but instead of compounding your money for 40 years, you compound your money for 39 years.

The difference? You will need to save around $14,500 annually instead!

Moral of story? Your Financial Freedom is HIGHLY dependent upon how EARLY you invest.

Takeaway Lessons:

1.      You need a budget so you can figure out how much you can invest each and every month.

2.      Financial Freedom is HIGHLY dependent upon WHERE and WHEN you retire.

3.      Inflation can easily double your cost by the time you retire.

4.      You are NEVER too early to invest.

Comment below if you found this exercise to by useful or would change anything about this step-by-step guide (again, this is just a rough estimation).