What’s ‘rich’ to you? There is no single definition. One I find as good as any is:
“How long you can live off your current assets, without lowering your current or desired lifestyle.”
The good thing about this definition is that it doesn’t set a dollar amount, compare you to anybody else, or mix up wealth and fame. Being rich is being able to live like you want, no matter what.
Consider John and David. John lives in a small but comfortable flat with his wife and 2 children. They travel twice a year, drive a mid-range car, go out to eat once a week. All in all, they spend US$100,000 per year.
John is an auditor, and he does well, but he’s not the head of the firm. For whatever reason, John has a net worth such that he goes to work every day knowing that even if he lost his job and essentially retired immediately, he’d have $100,000 to keep up his family’s lifestyle indefinitely. As you might imagine, that means he’s pretty relaxed.
David, on the other hand, makes several times more than John does. But he’s a banker and he has a lifestyle to go with it flat on the peak, tailored suits, top restaurants, and so on.
His career has always moved fast, so he always reckoned that he could save later, when he’s further up the ladder. He does have US$500,000 in assets, but, at his rate, that wouldn’t last long. So when his managing director asks him to come into the office on a Sunday evening, he drops whatever he’s doing right away. He knows who’s the boss!
By this definition, John would be wealthy, while David would be rather hard-up, even though to outsiders it might seem the other way around. So what would it take for you to be wealthy like John?
Well, let’s say an aspiring John puts away US$10,000 per year, every year of his working life, from the age of 22 until 65. Let’s say he earned a 5% return. To be clear, that would require that he invest in stocks, bonds and property rather than simply leaving his cash in savings accounts. By 65, he’d have a net worth of US$1.5 million (three properties of US$500,000 each, for example), which would allow him to draw down US$100,000 per year into his mid-90s. John retires rich, having saved the equivalent of an entry-level car or a couple of family holidays per year.
Now, we cheated a little. Why? Because if John is drawing down his savings, then you might argue that it’s not really income. So what if he’s really looking for US$100,000 in income, meaning that he doesn’t eat away at his net worth, so that he could pass it down to his children, and make them rich too (if it weren’t for estate taxes)?
Surely that would require much more money, right? To go from US$100,000 per year during retirement to US$100,000 per year forever?
Well, the maths is simple – if John earns 5% returns and wants US$100,000 per year, he needs US$2 million (that’s US$100,000 divided by 5%). So, as it turns out, going from US$1.5 million to US$2.0 million is all it takes to guarantee that that US$100,000 income is there for you and your family indefinitely.
Of course, US$500,000 is a lot of money – but in relative terms, it’s only a third more! John would have to save US$13,233 per year to reach that and guarantee lifetime wealth for him and his family.
That means that, even if his income were US$66,000 per year (respectable but far from what anybody would conventionally call wealthy), as long as he is willing to save and properly invest 20% of his earnings, John can actually make himself rich!
Now, not everybody is like John and starts saving from the age of 21. And what if you are a more conservative investor? Let’s have a look.
Let’s say John was a bit of a professional student for a while there, and also was a bit of a spender like David when he was younger. So he only started saving at 30. Well, he’d have to save quite a bit more each year.
To reach US$2.0 million at 65 he’d have to save around US$21,000 per year. The bad news is that late start means he has to save over 60% more each year. The good news is that it’s still a feasible amount for someone in his profession.
Now, what if, in addition to this later start, John gets a lower rate of return, say 4%? Maybe he’s afraid of investing in stocks and bonds, or maybe he just doesn’t look for the funds with the lowest fees and best performance. But that’s just a 1% difference, right? Surely it wouldn’t make that much of a difference? Or would it?
Well, to keep his US$100,000 income, John would have to have a net worth of US$2.5 million (that’s US$100,000 divided by 4%). So in a sense, the rate of return fell by a fifth (from 5% to 4%) and the retirement pot needed increased by a quarter (from US$2.0 to US$2.5 million).
That’s an extra property at US$500,000 that John will have to have because he didn’t optimise his returns. And to get there, he’ll have to save over US$32,000 per year. Still doable, but starting to get challenging.
In conclusion, wealth, in the sense of a US$100,000 passive income forever, is entirely achievable for an average middle-class professional. Starting early and ensuring you receive appropriate returns on your investments is the best way to get there.
