Tuesday, August 9, 2011

Monthly expenses' impact on financial independence or retirement

So let's say you'd like to be financially independent or retire.  You've become accustomed to a certain standard of living and a level of monthly expense.  How much are those expenses holding you back or helping you on your way to retirement?

My SO and I are both interested in becoming financially independent.  It's not that I don't want to work, it's more that I like having the option to not work or to choose or switch work situations without regard to money.  Once I've got a goal though I tend to be a little hell-bent on achieving it.  So I've been campaigning to slash our expenses for two reasons:
  1. Work (and my income) is ending soon and won't start up again for a while unless I find a really good part time job.
  2. The less we spend the more likely I am to meet my goal of paying for my MBA in cash and the sooner we can get to financial independence
So I decided to do a little math.  I made a spreadsheet that did a rough estimate of how monthly living expenses affected our years until financial independence.  Hitting financial independence was defined as having a savings nest egg that could cover expenses with a 3% withdrawal rate.  It ignores Social Security since we're not planning on it.  Check out the results graph:


The algorithm assumes you have no money now, expenses are always constant and ignores investment return.  Basically, if you spend exactly what you earn or more retirement is impossible since you will never get ahead and the closer you get to spending all your take home pay the faster your number of years to retirement increases.  The scale on this isn't very meaningful though since there's no way in hell we're spending more that $5,000 a month continuously.  So here's the graph zoomed in on a more realistic range of living expenses:

With monthly expenses of $4,500 we're about 80 years from retirement, but with monthly expenses of $1,500 we're about 10 years away.  Realistically we're somewhere between 15 and 35 years depending on what level of living expenses we'd like to maintain from $2,000 to $3,250.  What a big difference!  What you can see is that years to financial independence and monthly expenses are somewhat linearly related in this section of the curve.  For us this means that for roughly every $50 we cut from our monthly budget (permanently) we reach financial independence one year earlier.

It's solid ammo to take to my SO to cut our expenses a little bit, but it's not at all robust.  I'll get hammered since it doesn't include investment return, our current savings, changes in income or a multitude of other detailed nuances I just over simplified.  So expect to see beefier versions of this coming soon. Realistically, including investment return or income growth over time would reduce the benefit you'd see from cutting your budget.

Want to see how you stack up now? I've uploaded my speadsheet to Google Docs where you can download it and try it with your own data. Fields that you should edit are highlighted in yellow.  Click here to get a copy of my years to financial independence or retirement spreadsheet.  To input your numbers either save a copy or download the spreadsheet into Excel.

To get the cut $X get 1 year closer to retirement number pull the spreadsheet into Excel (unless you know how to do a trend line in Google Docs, in which case let me know!). Use File->Download As -> Excel in Google Docs.    Once you've opened the spreadsheet in Excel, right click on the data points in the second graph and select "add trendline".  Select linear and check the box for display equation on chart.  Once you have your equation it'll be in the form y=###x - ###.  Divide 1 by the first number (the one that is multiplied by x, in the graph above it's .021) to get the amount you'd have to cut per month to get one year closer to retirement.

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    1. I think this makes for a very good exercise, even though it isn't complete. It's a great tool to use for shock value - especially when someone doesn't want to tame their spending!

    2. Yes i agree, it definately is a good idea, At these financial times, it is getting more and more difficult to pay back loans, credit cards etc and the level of debt is increasing as nothing is being done about it.

    3. It is great to see that if you keep your living costs down, you can retire much earlier than if you don't.

      1. According to me the Retirement is a financial challenge for most of the people. So before suffering any kind of money problems everyone should have a good retirement planning, you need retirement plan advisors to get some best plans.

    4. This is a nice idea having the forecast in a graph format. Some people don't seem to realise how much money they are going to need when they retire, this is why putting funds into a pension when you are young is so beneficial in the long run.

    5. Cheers for a very good post. You have given me satisfaction to every post i read here. Hope you keep on sharing relevant information to all your readers.