May 2017 Net Worth Update

I just got back from a work trip, but wanted to make sure I kept up with my tradition of monthly net worth updates. Our May 2017 Net Worth increased by $6,470 to $664.267. 

May 2017 Net Worth Summary

Cash

Our cash balance went down slightly this month. We had to spend >$300 pumping out our septic tank and also spent most of the month on a low carb diet, which increased out grocery bill a bit more than normal. In May, we also paid for the materials to install a fence in the backyard. Now that school is out in our area, we’ve been wanting to allow the kids to play outside with less supervision and this will allow that. In the not-too-distant future, we may also be tearing down our deck and pouring a concrete pad in its place. None of these projects really will make a significant dent in our cash, but they will slow our growth and delay our acceleration of mortgage reduction. I expect our cash will stay around these levels for the next couple of months.

In May, we also paid for the materials to install a fence in the backyard. Now that school is out in our area, we’ve been wanting to allow the kids to play outside with less supervision and this will allow that. In the not-too-distant future, we may also be tearing down our deck and pouring a concrete pad in its place. None of these projects really will make a significant dent in our cash, but they will slow our growth and delay significant mortgage reduction. I expect our cash will stay around these levels for the next couple of months.

Because our accounts were hacked, my direct deposit was rejected on 5/31. Our old account numbers have all been closed and I missed the deadline by one day to have payroll make my deposit go to the new account. I’ve been out of the office but am told that there is a check on my desk for when I get back. These numbers assume that my paycheck had already been deposited. I feel blessed that missing a paycheck by a couple of days doesn’t really impact our lives like it would for many Americans.

Investments

The S&P 500 earned 1.16% in May and our investments continue to be primarily tied to that index. We had a little scare with some fraudulent activity in our accounts. Someone sold all our index ETFs and bought another stock. Everything is now resolved as if it never happened.

Most of our index funds are invested in ETFs. Whereas mutual funds can only be bought or sold at the end of the day, ETFs trade throughout the day like stocks. I like the flexibility of ETFs, but in reality, I don’t place many trades. I am considering changing to traditional index mutual funds ever since we were hacked. So far I haven’t made any changes but am open to suggestions.

Cars

Our cars continue to depreciate slowly but really nothing too exciting is going on in our garage. The only thing I really did this month was to change the oil and get a new antenna.

House

Similar to previous months we paid extra on our mortgage this month, decreasing our mortgage debt by about $1,100. The house value according to Zillow came down slightly, but overall our home equity increased. I’m excited to start paying A LOT more extra principal payments. Before we can do that, we first need to increase our cash and finish some home improvement projects.

529 College Savings

Our automatic investment to this account was missed this month because our accounts were compromised. I’ve since corrected this, but that explains why the account didn’t grow by as much as it has in previous months.

Summary

May was another pretty good month for us and June is already off to a great start. We are still on target to hit our 2017 Net Worth goal. I continue to be blown away at how quickly things have accumulated.

A Big Risk to Early Retirement – Inflation Risk

Lest you read my last post and think that I completely ignore the very real inflation risk in retirement, allow me to walk you through my thought process of how I account for it.

I already mentioned that when I project out our portfolio growth I’m assuming a non-inflation adjusted rate of return of 8%. If inflation were to average 2%, then my real return would actually be just 6%. I could just assume a lower rate of return, but I prefer to make some more granular assumptions about inflation.

It All Starts with Budgeting

Each year, I pull our full years’ expenses by category and make some minor adjustments to come up with a representative retirement budget.

First, I eliminate principal and interest payments on our house. Our mortgage will be paid off well in advance of retirement, so this won’t be needed. Next, I reduce our income taxes to account for lower income in retirement. I also reduce our charitable giving amount to account for us not having an income to tithe from, but not to zero since we will still want to be generous in retirement. Lastly, I eliminate any retirement account contributions since I won’t be eligible to contribute.

Not all of our expenses will be lower in retirement. I adjust our healthcare and travel expenses by assuming they will each be double current levels. Everything else stays the same. After all of these adjustments, I’m left with a budget that is roughly half of our household expenses. That sounds really low, but the majority of our current expenses are paying down the house, income taxes, and charitable giving so it is not unrealistic. In some categories like groceries, it may even be high given that we currently cover food for a family of six and will someday be empty nesters.

Inflation Assumptions

With this representative budget, I then apply inflation assumptions. The key difference here is that I use different inflation assumptions for different categories. Historical inflation has been 3-4% and I assume for most categories an inflation rate of 3%. The average for my lifespan hasn’t exceeded 3%, but it’s a real risk that it could be much higher. For me, medical expenses are the big wildcard. Not only do I assume they will be double my current level of spending, I also assume an inflation rate of 7% on medical expenses. If I were budgeting to be paying for higher education costs in retirement (I’m not), I would use a 7% inflation assumption for those costs as well.

Using this representative budget and specific inflation rates, I then inflate our expenses by the number of years between now and retirement to get an inflation adjusted retirement budget. Each year of retirement, I assume that expenses will continue to increase at the rates outlined above.

Inflation Impact on Retirement Income

One very interesting thing to consider is how inflation can eat away at your portfolio. For simple numbers, let’s assume you retire and have $1M worth of investments to live off of. It’s an oversimplification, but let’s also assume a steady 8% return, 3.5% inflation, and first-year expenses of $60,000. Since $60,000 is 6% of $1,000,000 and you’re earning 8%, then you can live off the earnings forever, right? Wrong.

You see, what happens is that even though you are consistently earning 8%, the growth of your earnings is lower than that because you aren’t reinvesting all of those earnings. Because your expenses are growing at 3.5%, and your income isn’t growing as quickly, your expenses will actually be greater than your income after just 15 years. After that, you begin whittling away your principal until year 33 when you run out of money entirely.

In this way, inflation is one of the biggest risks to early retirement. Everyone is impacted by inflation. The longer your retirement, the more time inflation has to grow and exceed your investment income.

Below I’ve outlined what hypothetical portfolio values would be with the assumptions outlined earlier.

How to protect against inflation?

There are a few things I am doing to protect our retirement dreams from inflation. The first is to have an initial withdrawal rate much lower than 6%. In your working years, you want to have as big a gap as possible between income and expenses. In retirement, you want to have a gap between expected investment income and expenses. Whether you plan to spend most of your money in your lifetime or leave an inheritance, inflation can derail either of those plans.

The primary other strategy is to remain invested in stocks. Over time, stocks are the only asset class that has consistently outperformed inflation. While earnings growth may not exceed inflation, left untouched a diversified stock portfolio would not lose purchasing power over time.

There are many ways to account for inflation in retirement planning, but this simple method works for me for now. It is absolutely something you don’t want to ignore, but I don’t lose sleep over it either. What are your inflation assumptions?

Assumptions for Early Retirement

I recently was talking to a friend who disagreed with my retirement planning assumption that our investments would average an 8% return. I had felt that my assumption was conservative given that I am close to 100% invested in equities. He felt that 4-5% was a better long-term assumption. Dave Ramsey assumes 12%. Who is right?

At the end the day, who really knows? We’re doing our best to save and invest a good chunk of our income and staying invested in the asset class with the best track record and best potential growth. But the conversation did get me thinking so I did some additional research.

Over at Moneychimp.com, there is a great resource that shows annual returns on the S&P 500 going back to 1871. You can look at any date range and see returns adjusted for inflation. This is great data for us because the majority of our portfolio is in index funds that track the S&P500. Their biggest takeaway is that:

“Over the very long run, the stock market has had an inflation-adjusted annualized return rate of between six and seven percent.”

When I assume 8% return, I’m assuming that to be before inflation. Is that what my friend meant? I don’t think so, but I’ll have to follow up. My impression was that he was just particularly pessimistic.

I was curious though, so I did some digging into the data set and found some things worth sharing (all numbers not adjusted for inflation).

S&P 500 Historical Returns

  • The best 1-year return for the S&P 500 was 56.8% (1933)
  • The worst 1-year return was -44.2% (1931)
  • Average annual returns from 1871-2016 were 10.7%

As you would expect, the longer you invest the more likely that you wouldn’t have lost any money.

  • The best 5-year annual return was 29.8% (1924-1928)
  • The worse 5-year annual return was -6.9% (1928-1932)
  • The average 5-year return was 10.7%/yr

It took going out to a 10-year time frame before there were no periods where you would have lost money. Investing in the worst 9-year period of 2000-2008, you would have averaged -1.7% per year.

  • The best 10-year annual return was 21.6% (1949-1958)
  • The worst 10-year annual return was 0.6% (1999-2008)
  • The average 10-year return has been 10.8%/yr

Our Retirement Plan Assumptions

The length of time I’m really interested in is even longer than 10 years. My goal is to have my working years last around 25 years and then to be retired for 40+ years. I’m about 10 years in with another 15 to go.

  • The average 25-year period has been an 11.1% return
  • The best 25-year period was 18.2% (1975-1999)
  • The worst 25-year period was 5.8% (1872-1896) 

We first started saving for retirement in 2006 and average market returns from 2007-2016 have been 8.8%. Our returns have been slightly higher than this, but aren’t as clean to track since we have been continuously investing new money for the past 11 years.

All this to say, we’re assuming 8% returns over the next 15 years and based on what we’ve seen so far and what has happened long before we started investing, we remain comfortable with that assumption.

I should have even more years in retirement than in my career, but my plan assumes a low withdrawal rate, under 4%. In retirement, we won’t be relying on sustained market returns to provide for our lifestyle but will remain invested primarily in equities similar to the strategy outlined in Simple Wealth, Inevitable Wealth.

I’m currently reading Nassim Taleb’s book Antifragile and he makes the very valid point that until the worst of anything happened, it wasn’t actually the worst. Said another way, just because a mountain is the tallest you’ve seen doesn’t mean it’s the tallest in the world. I know that future returns could be worse (or better) than we’ve ever seen before, but planning on an early retirement allows me to have sufficient margin in my plan to compensate for unexpected downturns.

See below for some more info on different investment horizons high, low, and average annual returns for a specific number of years.

What rate of return do you use for your retirement planning assumptions?