Few of us go through our entire careers without at least thinking about the prospects of retiring early. Perhaps it is after a difficult period at work. Perhaps after a special vacation.
Many people have no choice but to retire early. It can become harder to keep up with work as we age. Especially if it involves physical labour. Even in non-physical vocations it can become more challenging to gain new skills over time. Workers also may face age discrimination later in life.

There are steps that can be taken to prepare for early retirement. Like any financial challenge all it takes is a plan and some foresight to prepare for whatever life has in store for us.

At a high level the planning process for early retirement doesn’t differ too much from retirement planning. Estimate how much it is going to cost, set a goal and design an investment strategy to meet that goal. However, there are nuances that need to be considered. Below are three things to think about:

1. Taking care of retirement first
2. Build a financial bridge to retirement
3. Reduce future expenses

Listen to the full episode below. Alternatively, read the full article here.

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You can find the transcript to the episode below.


Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances, or needs.

Mark LaMonica: Okay, Shani. So, a couple things have happened today. You are sitting by the window at the office.

Jayamanne: Yes.

LaMonica: And you send me this Teams message telling me that there are three dead birds outside of your window.

Jayamanne: And they were like perfectly spaced on the awning.

LaMonica: Like they flew into the window in formation.

Jayamanne: Yes.

LaMonica: Yeah. So, I don't know how you feel about that. You obviously hate birds. But…

Jayamanne: But I don't want them to die.

LaMonica: Just leave. Like, leave the country.

Jayamanne: Yeah, like, leave me alone. Yeah, exactly.

LaMonica: The other thing is you've been very busy updating something that we have not updated for a while. So, you want to talk about that?

Jayamanne: Yeah, we haven't really had capacity in our team to keep the podcast resources page up to date. So, what we've been doing is basically just putting the links straight into the copy for our podcast episode that I've gone through, and I've updated the podcast resources page. So, apologies if you have clicked on that and it hasn't been updated for a very long time. But all of the resources are there now, and we will make sure that we keep updating it.

LaMonica: Okay. So, between this bird apocalypse and the fact that you're doing tedious work and updating these podcast resources, you've probably been thinking a lot about retiring early.

Jayamanne: That's a good segue and yeah, constantly.

LaMonica: Yeah. So, I figured that even before you had to do this work and the birds flew into the window. But today, we're going to talk about how to set yourself up financially to retire early. And there are a couple of different ways to think about early retirement. The first, of course, is people who voluntarily decide that their goal is to retire early.

Jayamanne: But it's also worth considering people who retire early for other reasons. One could be just not being able to physically continue with work. It also happens because it is hard to stay employed as you get older. Older workers continue to face age discrimination and the perception that they can't keep up with the changes in the workplace and new technology. Older workers typically make more money and continue to justify to an employer that they are worth it on a cost-benefit perspective. That becomes harder as you age.

LaMonica: And that, of course, is trickier because as listeners know, we are big proponents of planning. And this is an unplanned event, but also something that we think people should be aware of because it's not an outlier scenario. It happens quite frequently.

Jayamanne: So, let's start with the basics. We of course encourage listeners to spend some time thinking about retirement long before it happens. The earlier this is done, the better. That includes creating an estimate of how much you will spend in retirement and designing a saving and investing plan to build a portfolio that can support those spending needs. We've covered this in other episodes, and we'll include links to those episodes in the show notes.

LaMonica: And the podcast resource page, right, Shani?

Jayamanne: Exactly.

LaMonica: There we go. And at the center of a retirement plan is taking advantage of the tax benefits that are provided for retirement savings in many countries. And that is superannuation in Australia. Those tax benefits are substantial, yet they come with some rules. And the most important rule when we're talking about early retirement is the preservation age or when you can access those retirement funds.

Jayamanne: And we will get back to the preservation age in a minute, but our guidance is to prioritize savings into superannuation when you're young. And I know this sounds counter-intuitive because people tend to focus on what is immediately in front of them and it's easier to ignore retirement when you're in your 20s, 30s and even 40s because it's so far away. But the earlier you can get funds into super, the longer you have to take advantage of those favorable tax rates.

LaMonica: It also provides more flexibility later in life because you aren't trying to make up for a shortfall in retirement savings. That flexibility can enable you to potentially retire earlier or deal with a non-planned early retirement. And that is the whole point of spending time figuring out and managing your finances, enabling flexibility because we never know what twists and turns life will provide.

Jayamanne: Let's get back to the preservation age. As we said, the preservation age is when you can access super in all but a couple of really specific circumstances around permanent disability or medical conditions. For most people listening to this podcast who are considering early retirement, the preservation age, if you are no longer working, is 60. That applies to everyone who was born after the 1st of July 1964.

LaMonica: And that is our definition of early retirement, retiring prior to 60 or your preservation age. And it should be obvious that if you want to retire before 60, you need assets outside of super. And there are two ways to retire early. The first is what we're going to call a bridge to super.

Jayamanne: The bridge to super is having funds that can pay for life prior to the preservation age. And the prerequisite to considering a bridge to super is knowing that you'll have enough in super to support you once you get to 60. But let's spend some time talking about the bridge to super.

LaMonica: As we mentioned, this is money saved outside of super that can be used to support your living expenses until super can be accessed. This could be a share portfolio you've built up, could be an investment property, or it could just be cash that has been saved. It is worth considering how these funds can be converted from financial assets into cash that will support day-to-day living expenses.

Jayamanne: That is obviously easy if the savings are in cash. Since it's already in cash, you can just spend it. This becomes a little trickier if you have a share portfolio or own an investment property. And we're going to go with the assumption that you are not able to live off income generated by either dividend-paying shares or through rent on an investment property. That is obviously an ideal state for someone planning for an early retirement. If that is your goal or if that is what you've been able to accomplish, then hats off to you. That eliminates a lot of challenges that we will talk about.

LaMonica: But it's more likely for most people that asset sales will have to be used to fund life. And there are really two different ways to think about this. Scenario one is planning on exhausting those funds prior to preservation age. And we can use an example to illustrate how this works. Let's say you have spending needs of $50,000 a year. Simply figure out how many years early you want to retire and that can form the basis of your savings targets.

Jayamanne: And this is fine if it is a couple of years, but if you're looking to retire for a good deal of time, let's say more than five years before preservation age, then there are a couple of other considerations. The first is inflation. Discussions about inflation a couple of years ago seemed more theoretical, but it is in front of mind for many people these days. Accounting for inflation is assuming that while you may have $50,000 of spending needs in the first year, it will have to increase. And that means saving more money.

LaMonica: The other thing to think about with an earlier retirement is asset allocation. If you want to retire two years prior to preservation age, a strong case can be made for keeping those two years' worth of spending in cash. That is a short timeframe, and of course, the market can drop significantly. But if you were looking at five or more years of not working prior to preservation age, going all the cash may not be the right approach.

Jayamanne: And that doesn't mean there aren't risks to that strategy. A market plunge can of course happen at any time, and that can have a profound impact on your spending, and you'll want to protect yourself against that risk. One approach is to get more conservative in your asset allocation. Defensive assets can of course also go down in value. We've certainly seen that in the last couple of years as bond prices have gone down in the face of rising interest rates.

LaMonica: What doesn't go down in value is cash. So, this could be a situation where an early retiree would consider a mini-bucket approach for non-super assets prior to retirement. A bucket approach involves keeping money in cash that can be used for spending needs if markets fall. If they don't fall, shares and bonds can be sold off to meet spending needs. But if they do, you could leave that money invested to wait for a recovery and cash could be spent. How much is kept in cash is based on how many years early you retire and how risk averse you are. The more that is kept in cash, the longer you can withstand poor market conditions without selling shares and bonds. If you are very risk averse, multiple years of spending can be kept in cash.

Jayamanne: And if you are retiring early and have amassed a good amount of non-super assets in comparison to the years early you want to retire, you may want to consider a withdrawal amount that allows those as assets to support spending even after preservation age is reached.

LaMonica: We have covered withdrawal rates extensively. And as part of those discussions, we have talked about the 4% rule a lot, talked about where it came from and the drivers behind any withdrawal rate. And to summarize, a safe withdrawal rate is supposed to protect people from risks that decrease the amount of time a portfolio can support them. So why don't we remind people what those risks are, Shani?

Jayamanne: The first risk that we talked about is big market drops. That is a problem early in the period you are withdrawing money because you are selling after your portfolio has dropped significantly, which leaves a smaller portfolio to recover when markets go back up. We talked about addressing the risk with bucket portfolios.

The second risk is that inflation goes up significantly because the 4% rule only addresses how much is taken out the first year. After that, the dollar amount increases by inflation. The more inflation and the more that is taken out, which will also impact how long a set amount of money will last. And the third is how long you need the portfolio to last. And this is obviously a big risk of retirement because you don't know when you will die.

LaMonica: Withdrawing money from a portfolio to support early retirement is a little different. You have enough money in super to support your retirement needs. You only need this portfolio to last until preservation age. But for an early retiree who wants this non-super portfolio to last into retirement, it's worth thinking about how long it needs to last.

Jayamanne: And this is where it's good to think about spending patterns in retirement. We tend to spend more money early in retirement because we're more active and we do more. So, one approach could be looking at when you think you would start to slow down, which will likely reduce the amount that is spent.

LaMonica: So, let's take a hypothetical situation. Somebody retires at 50, which leaves them a 10-year gap until preservation age when super can be accessed. If a decent amount of money has been amassed in non-super accounts that would last a retiree more than 10 years, perhaps a different approach could be taken. Knowing that more money will be spent early in retirement, the early retiree could target the non-super assets to support spending for 20 years until they are 70. For the first 10 years after preservation age, they could spend more money.

Jayamanne: And this may fit in with what many people do. Some people don't want to retire completely, but perhaps they want to work less and go part-time. Perhaps they want to do a different type of work that pays less. This money could make up for the differences in salary.

LaMonica: And if you only want your money to last 20 years instead of the assumed 30 years that is built into the 4% rule, you can take more out. And Morningstar has done a lot of work around assumed withdrawal rates using different asset allocations and accounting for different levels of success based on the three major risks we talked earlier about, poor markets, inflation, and living a long time. Well, if you reduce the time a portfolio needs to last under these poor scenarios, with a 90% success rate, the amount you can take out goes up. For 20 years under some assumed asset allocation scenarios, the amount goes up to 5.5%. At 15 years, it goes up to 6.9%. And at 10 years, it goes up to 10%.

Jayamanne: And if those risks don't actually come to fruition, the portfolio will of course last a long time more. So, something else to think about for early retirees that are considering a set withdrawal scenario.

LaMonica: Okay, we need to talk about one more consideration if you were planning for an early retirement. That is taxes. One of the great benefits of super is, of course, the lower taxes on dividends and capital gains prior to preservation age. Yet perhaps the biggest benefit is that once you've reached preservation age and gone into pension mode, you pay no taxes on capital gains and dividends for those assets that you keep in your pension account. Well, that is obviously not the case with someone that retires early. Money held outside of super is taxed at your marginal tax rate for capital gains and dividends.

Jayamanne: Now, it's likely of course that you're going to move into a lower tax bracket if you quit your job or just work part-time. But just remember that the withdrawal rate you use needs to be considered pre-tax.

LaMonica: Okay, we have one last thing for listeners to think about if planning an early retirement. And it's related to the tax discussion we just had. Talked about how assets can support spending, but reducing the amount spent is far more valuable than having more money. That is especially true when you consider taxes. Less spending means you need less money to support your day-to-day life. There are lots of ways to spend less. You could of course make changes to your lifestyle. You could move to a cheaper location. But the number one way to reduce spending is to focus on the largest expense that many people have in their budget and that is housing.

Jayamanne: If you own your own home, that means getting your mortgage paid off. And this can happen in a couple of ways. If you live somewhere expensive, you could sell your house and move somewhere cheaper, where you could buy a house outright with the equity built up in your home. Or you could downsize to a smaller place, but you could also focus on paying off your mortgage.

LaMonica: The problem with a mortgage is that getting closer to paying it off doesn't do you a whole lot of good. The real key is crossing that line where it's paid off completely and that monthly expense disappears altogether. So, as you're coming up with a plan to retire early, don't just focus on building up the non-super savings you have. Figure out if there's a pathway to reduce major expenses as well.

Jayamanne: And just think about how much money you could save. At a 5% withdrawal rate and a $3,000 a month mortgage paying that off would mean you would need $720,000 less in savings. And that is before we account for any taxes. So that, of course, is huge.

LaMonica: So that is our episode on retiring early. And since neither of us have figured out a way to do that, we will be back next week with another episode of Investing Compass. As a reminder, the three steps we've outlined are taking care of super savings first, building a financial bridge to retirement, and focusing on reduced expenses. So, we'll now go back to our desks, see if there are more birds outside of Shani's window. And we, of course, would appreciate any comments or ratings in your podcast app or send me an email with any comments about Shani's hatred of birds.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)