4 Steps to Early Retirement Through Passive Income

The thought of early retirement for many people is an un-achievable construct. But if you are a millennial you have time on your side. See, early retirement isn’t hard in a certain sense. It isn’t like learning quantum mechanics, and trust me quantum mechanics is hard. I did several quantum mechanic papers at university, and I am still don’t fully grasp all the concepts.

Early retirement is only hard as it requires discipline and delayed gratification. That’s it! And everyone can learn these skills. And if you are a millennial, you have a minimum of three decades before your socially constructed retirement age of 65, plenty of time!

So here are the 4 steps to early retirement.

Yes, there are only 4 steps to early retirement. That means it is 3 times easier than the 12 step program… sorry that’s my attempt at being funny. In all seriousness though;

1. Save As Much As You Can

You want to save as much as you can! We’re talking upwards of 30% of your income. Some would say that isn’t far enough either, and I totally agree. But don’t go all out and save 90% of your income. You might be able to do this for a short time, but you will more than likely blow out and start spending again.

Start by saving as much as you can and aim for 30%. Once you have achieved this, you can review your expenses and start optimising your life.

If you are struggling to save, think of every dollar you earn as a little worker. Once you have this little worker, they will work for you forever and ever. And once more, given enough time, this worker will produce other workers who will also work for you.

Let’s see what one dollar saved now is worth to you when you retire;

$1.97 if you retire in 10 years

$4.17 if you retire in 20 years

$8.83 if you retire in 30 years

And, $18.72 if you retire in 40 years.

In ten years your little worker has now become 2 workers! And in 30 years…. your have nearly 9 workers.

Now I can already hear people yelling at the screen, “ $1.97- is that it?”

If you are thinking anything along those lines, it would be best to go back and read this post, and this post, on exponential growth! If the fact that you had one dollar, and then it’s value increased to $1.97 doesn’t boggle your mind then, in all honesty, there is no hope for you in early retirement and passive income.

Just think, if you could save all your income for one year, say $45,000, then in ten years that is worth $88467! You have just saved yourself two years worth of work to gain that money, meaning that you can retire two years early!

The calculation above uses a 7.8% rate of return before inflation/fees. This is the average return rate for the NZX50 over the last 60 years, which is lower than the US500 long term average of 9.8%.

2. Invest Those Savings and Any Returns on Those Savings

Now saving money by itself isn’t going to get you far. You need to invest that money! And I am not talking about savings accounts in banks. Here in NZ, the going rate for savings account at the bank is well below 0.5%. It doesn’t even keep up with inflation.

You need to invest your money somewhere you are getting decent returns. I would call anything about 4% a decent return, but higher is always better!

If you are a young millennial, you can afford to take more risky investments and gain higher returns, but I am no financial advisor. You will need to find out what level of risk you are willing to take. You can look for higher returns with a bit more risk associated because you have time on your side.

My method is to have many different types of investments at different risk levels. That way, if anything unforeseen happens, it is unlikely to affect all your investments. Diversification is key.

A low fee index fund is a good option. Always keep an eye on the fees that a fund provider is charging. The fee mighty look small, but it can take a large chunk of your profit due to compounding. There are even cases where the return is higher, but the fee charged means a low-cost index fund would have probably been better off. I might look into building a simple calculator to work this out!

3. Work Out How Much You Need to Have Saved to Live on the Passive Income Generated

This is your target. You need to know what you are aiming for. If you are saving without a target, you will burn out. You need to keep yourself motivated and track how close you are to reaching your target.

You need to say; if I have X amount saved and invested, I can retire and live off the passive income if I choose to. This gives you motivation.

How do you calculate the amount needed to retire?

To calculate the amount you need to retire, you need to figure out how much annual income you would need to live off. A good place to start is what you are currently spending. And maybe you want to add a bit more for hobby expenses, or what else you are planning on doing once you aren’t dependent on your salary.

So if you currently live on around $25,000, at a 4% withdrawal rate, you will need $600,000 saved. Now saving $600,000 does sound a little daunting, but you have to remember when you save your little workers, they will make new little workers.

Remember, you are not saving 1 million dollars just from your salary, your money will work for you! Let’s see how long that would take, estimating that you will get a 6% return on your investments.

At $10,000 saved per year, it will take 26 years

At $15,000 saved per year, it will take 20 years

At $20,000 saved per year, it will take 16 years

It is a good thing that we millennials have 3 decades before society says we have to retire.

4. Retire

The final step of the system is actually to retire. Now a lot of people ask me what I would do if I actually retire decades early. Many friends think that I would get bored and go back to work. And that is fine. The point is, you want to get your money working for you through passive income, rather than working for money.

Suppose you choose to work when you retire because you enjoy it. That is perfectly fine- that can be part of your personal financial independence definition. My retired father works full-time driving heavy machinery. Not because he needs the money, but because he enjoys it. Perfectly fine! Work can be much more enjoyable if you have don’t have to stress financially.

I think I will take up many of the hobbies that take a back burner these days. Continue my flight lessons, finish my woodworking projects, and expand my veggie garden. There will also be a lot of travel.

That is what I am looking forward to when I retire early using the above 4 steps. The whole process is straightforward. You have to be disciplined and continue on your savings and investing plan. Even though your friends and colleagues around you are buying fancy new phones, cars, and there McMansions filled with their designer furniture. All while going out to dinner every night.

Just remember that in ten years or so, you will be financially better off than them. You will start to see the passive income coming in. It will just keep exponentially building on that!

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