Welcome to Business is the Best Medicine’s Personal Finance Basics for Medical Professionals. Lesson 6 is the final installment of this series, which is a curriculum designed to make you knowledgeable and confident enough to manage your hard-earned finances. If you haven’t already read Lesson 5, please click here.
In the first five lessons in this series, we have introduced personal finance, discussed some general principles, and thoroughly explored the 10 steps you should follow as a roadmap to financial independence. Up until now, we have kept the idea of financial independence vague. In Lesson Five, we will explore what that idea really means and answer the pressing questions, “How much do I need to retire?” and “At what age can I stop working?”
FI, FIRE, or FI(RE) – You Choose
Retirement in the US traditionally means working until age 65, then living off one or all of the following sources: a pension, social security, and a 401k. However, only 6.8% of retirees have all three. Many Americans save little outside their mandatory FICA contributions, leaving 40% of retirees living exclusively off social security.
The Financial Independence Retire Early (FIRE) movement touts practicing frugality in order to achieve a very high savings rate (at least 50% of their income). By keeping their life’s expenses low and saving at such an accelerated rate, the goal is to build up enough assets to retire early – and by early they generally mean as quickly as possible, often in their 30’s or 40’s.
Early adopters of the movement were focused on keeping expenses as low as possible, often to the point of deprivation. The FIRE dream is to retire as soon as you can and not spend your life working a job that you hate. While the principles of FIRE are sound, not everyone hates their job, wants to retire early, and wants to live in austerity.
Enter FI, the concept of Financial Independence, without tying it to retirement. Pursuing FI follows the same basic tenets of FIRE – live frugally and have a high savings rate, but the goal is not to retire as soon as possible. The goal of FI is to have a good life now, not depriving yourself of every pleasure just to retire a few months earlier, while still actively planning for your future. Pursuing FI means having options.
I think of these retirement philosophies as a spectrum. On one side, you have FIRE, which allows you to retire early at the cost of a diminished lifestyle, and on the other traditional retirement, which delays your retirement by inflating your lifestyle along the way.
I believe all high-income medical professionals should aim for financial independence, whether or not they plan to retire early. I like to use FI(RE) to denote these two variations of the same general theme. You get to choose how aggressively you pursue early retirement.
The Multi-Million Dollar Question
How much money do I need to retire? This is the multi-million-dollar question, or is it? Traditionally, the answer to this question was a dollar amount, conceived without much thought or individualization. Physicians need $5 million or $10 million to retire. Period. However, it’s easy to see that this approach has some serious flaws. Why would a pediatrician need as much money as a neurosurgeon in retirement? While both physicians, their incomes are quite different.
A more refined approach was to assume you needed 20x your income saved for retirement. A pediatrician making $200,000 per year would need $4 million, while an ER doctor making $500,000 a year would need $10 million. While this solves the specialty riddle, it isn’t scientific and doesn’t consider individual spending patterns. If two ER docs make $500,000 annually, but one only spends $150,000 a year while the other spends $300,000, why would they need the same amount in retirement?
Enter the 4% Rule, or more accurately, the 4% Rule of thumb.
The 4% Rule
The 4% Rule, also known as the Trinity Study, came from a Trinity College research paper published in 1998, which set out to answer the question, ‘What safe withdrawal rate allows you to survive 30 years in retirement?’
The study assumed that once you retire, you will never work again. Your retirement nest egg will be invested in a mix of US stocks and bonds from which you will withdraw a specific amount of money each year, fixed at the time of retirement, except with an annual adjustment for inflation. The investigators examined a variety of asset allocations and withdrawal rates to determine the optimal “safe” combination.
The authors reviewed every 30-year period since 1900 to examine safe withdrawal rates from retirement portfolios constructed of various mixes of stocks/bonds. This study was designed to find the maximum “safe withdrawal rate” that worked even in the worst-case scenarios, for example, if you retired just before the Great Depression, WWII, or the Great Recession. The chart below demonstrates the percentage of the time each portfolio lasted 30 years at increasing withdrawal rates.
For example, if your portfolio was a mix of 75% US Stocks and 25% US bonds, you could have withdrawn 3% of the starting balance every year for 30 years without running out of money in 100% of the periods examined. However, the study determined that the ideal mix was a 50% Stock / 50% Bond portfolio with a 4% withdrawal rate. While this was “only” successful 95% of the time, if was found to allow the highest withdrawal rate with the least amount of volatility (the more stocks in your portfolio the higher the volatility). The study was designed to be ultra-conservative – again, it was trying to find the maximum safe withdrawal rate even in extreme circumstances.
By being so conservative, the average retiree left a lot on the table, so to speak (see the table below). The study demonstrated that the median retiree using this method had an ending balance after 30 years of nearly 3x their starting balance! Because this was the median, half of the examples ended up with less, while half ended up with more.
The 4% Rule can be extrapolated to assume that you need 25x your annual expenses to safely have a 30-year retirement (25 is the inverse of 4%). If you spend $40,000 per year, you need $1 million. If you spend $200,000 per year, you need $5 million.
Although this research was intended for a traditional retiree living 30 years from 65-95, it became a cornerstone of the FI(RE) movement. It is important to note that the research was never meant to be used for early retirement, and adjustments must be made if you plan to retire early. However, it is a great place to start. Its authors have also updated the study, and other researchers have replicated its results.
How Much Do You Need to Retire?
The Trinity Study method would have worked through the worst 30-year periods in modern American history, so if there is another Great Depression during your retirement, you won’t be left eating cat food. If you have an average 30-year period, you will end up with 3x the amount you started with. So, the answer to the question is 25x your annual expenses IF you follow the investment pattern outlined in the Trinity Study.
Remember the Golden Formula outlined in Part 1 of our series? The less you spend and the more you invest, the larger your investable assets will become. Putting the 4% Rule and the Golden Formula together, the less you spend, the less you need to retire, and the sooner you can stop working.
Note that your annual budget is what you actually spend every year, not your annual income. An ER doctor making $500,000 a year may contribute $50,000 to a pre-tax retirement account (SEP IRA) and pay $150,000 in State and Federal income taxes. This leaves $300,000 in take-home pay. If another $100,000 is invested annually, the actual budget is $200,000, and the amount needed for retirement is $5 million.
How Long Do You Need to Work to Reach Financial Independence?
The answer to this question depends on your income and your savings rate. We have already established that you will make a high income as a medical professional, but we now know that isn’t enough. The real issue is how much you save/invest per year, which will depend on several factors. How much are you going to work? How much do you owe in student loans? How long are you willing to delay gratification? And how frugally are you willing to live?
This chart demonstrates a theoretical guide to how long it will take you to reach FI(RE). If you don’t save and invest money, you can never retire. This is theoretical because we all pay FICA taxes, which include social security. So, more accurately, if you save 0% of your net income, you will only be able to retire off social security income.
Unfortunately, this actually happens to some medical professionals. They spend every dollar they make and wake up one day to realize they don’t have any money saved. The only options are to keep working (if they can) or live well below their previous lifestyle in retirement.
At the other end of the spectrum, if you save 100% of your net income, you can just retire now, since you obviously are getting money from another source! Perhaps you have a wealthy spouse or inherited a lot of money. Congratulations, you don’t need my help.
The rest of us will land somewhere in the middle between these two extremes. For physicians, we usually start our careers at about age 30. If you save 25% of your net income, the minimum I recommend, you can retire comfortably in about 30 years. The math is slightly different for medical professionals who start working in their early or mid-20s, such as many APPs. To view a head-to-head comparison between the financial life of a Family Medicine Physician and a PA, click here.
Final Thoughts
Whether you want to retire early or work until you’re 80, it is important to map out how much money you will need. Using the 4% Rule, we can answer two pressing questions – how much will I need to retire, and how long will it take me to get there at my current savings rate? We can calculate how much we need to have invested in order to retire by multiplying our current annual expenses by 25. Further, based on our current savings rate, we can use the table above to estimate how long it will take to save that much. Understanding these two calculations gives us the power to make changes needed to achieve the goals we set in Lesson 2.
These adjustments could be to make more money, spend less, work longer, or the exact opposite. It all depends on what you want. However, of all the changes you can make to your finances, keeping your expenses low is the most powerful because it gives you a double benefit. First, the lower your annual expenses, the less money you need for retirement. Next, spending less increases your savings rate, allowing you to reach your retirement number faster!
Obviously, the future is not guaranteed to be the same as the past. No retirement planning method can predict the future or guarantee results, but the Trinity Study methodology is the best we have. Besides, if we experience something worse than WWII or the Great Depression during our retirement, we’ve got bigger problems than simply maintaining our current lifestyle.
This concludes The Basics of Personal Finance Series. I hope you have enjoyed these 6 lessons and have learned enough to get started on your own personal financial journey. Stay tuned for Part II of our The Basics Series, The Basics of Investing: Stocks & Bonds. As always, if you have any questions or comments, please leave them below. Also, subscribe to Business is the Best Medicine so you don’t miss any future content.
