By Philip Brewer on 3 November 2009 (Updated 10 February 2010) 11 comments
Photo: Philip Brewer

If you're tracking your spending, you know how much money it takes to live on. If you're tracking your investments, you know about how much return you're getting from your capital. With those two numbers, you can get a pretty good estimate of how much money it takes to buy your way out of the rat race.

In its simplest form, the cost to buy your way out is just your annual spending divided by the return on your investments. I used to do that calculation a lot. When I got my first job interest rates were in double digits, so I could imagine getting \$30,000 or even \$40,000 a year — plenty of money to live on — from an investment as small as \$300,000.

## A simple theory

Of course, that model is over-simplified. For one thing, you have to account for the possibility that in some years spending will be higher. (What if you need a new car or a new roof or to send the kids to college?) I knew how to handle that one, though: The same way I was already dealing with it when my income came from a regular job — covering major expenses by cutting other spending.

More fundamentally though, the simple model doesn't account for inflation. And, at the time when interest rates were in double digits, inflation was similarly high. It wasn't a problem you could just handwave away.

I spent way more time than it was worth trying to construct a mathematical model for living off capital — a model that accounted for taxes, provided for reinvesting enough after-tax income to keep me even with inflation, and still paid out enough money for me to live on. All this, mind you, while my net worth (after a student loan) was probably negative.

Anyway, that was my first guess at my number: a capital sum of \$300,000, properly invested, would yield enough that I wouldn't have to work. That's what it would have cost me to buy my way out of the rat race. Other people have done the same sort of thinking and written whole books about it, and come up with better-researched models for accounting for taxes and inflation. I've written reviews of a couple of good ones: Bob Clyat's Work Less, Live More and Joe Dominguez and Vicki Robin's Your Money or Your Life.

## The less simple reality

In practice, though, for most people, buying your way out doesn't work out.

First of all, it's really expensive. Unless you're extraordinarily frugal, it's still going to cost you tens of thousands of dollars a year to support your household. And (as you can't really count on double-digit returns on your investments), it turns out that you need around a quarter million dollars to stand behind each \$10,000 of annual income.

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More fundamentally though, no amount of capital provides complete security. Your money can be lost any number of ways. The economy could turn down. Even if the economy goes up, your investments could go down. You could lose your money to theft, natural disaster, lawsuits, or government seizure (not to mention simple overspending). You can try to protect against any of those things through a combination of due care and proper insurance, but there's no such thing as perfect protection.

Your real protection against those things is your own productive ability — which is something that can't be stolen, taken in a lawsuit, or seized by the government.

Buying your way out of the rat race is a suboptimal strategy. It can work — people do it all the time, although not very many of them — but it's hard. It also doesn't leave you so very much better off than you were — you may be able to quit worrying about losing your job, but you have to start worrying about low interest rates.

Now, accumulating some capital is a great idea. In fact, I think everyone should have a medium term goal of accumulating enough capital that the income from their investments could cover their bare minimum expenses. Once you get beyond that, though, adding more capital starts yielding diminishing returns.

## The real way to escape the rat race: Refuse to race with rats.

So, what do you do instead? Basically, invest in your own skills.

Improving your skill at the job you already have can help you earn more (important if you don't yet have that basic level of capital), but developing skills at entirely new things gives you a whole new layer of protection against economic downturns and incompetent managers.

Broaden the kinds of work you look for. Don't focus only on finding the highest pay — look for work that's interesting and that's useful. It's more fun. It's also more secure — there's only one job that pays the most.

Beyond that, learn how to do, make, grow, and find things for yourself. To the extent that you can directly provide the things your family needs, you're not dependent on either your capital or your job.

Each of these things improves your security. Taken together, they can give you as much security and freedom as a human being can achieve.

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11 discussions

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I bought my way out through the ultrafrugal approach.

It is important to realize, that you can never get full security regardless---you could get hit by a bus and not be able to apply the diversified skills anymore. (Try to pick manual skills as well as mental skills.)

I think financial independence by having 25-30 times annual spending as a backing is definitely a strategy that should not be dismissed and it should be included on par with finding (different) jobs that can yield the same levels of income to cover one's expenses. Something that makes this easy by lowering expenses is the pursuit of ultrafrugality which is complicated but not very hard.

Overall, we seem to agree, but I would have pushed the asset-backed "buy-out" harder.

"Remember, young people: even if you win the rat race, you're still a rat."

Phil,

Your article talks about setting up a "perpetuity", but what you really want is an "annuity".

When interest rates are high and one has a lot of years left to live, then there's not a lot of difference between the cost of an annuity and perpetuity.

However, when interest rates are low (say 3%) and one has maybe 40 years to live, the cost of an annuity is only 70% of the cost of a perpetuity with the same regular pay-outs.

@ Rick Miller:

You're right.  I actually analyze this in some detail in my post How much do I need to retire?  How much can I spend?

There's a lot of cultural and institutional support for people who are escaping the rat race by retiring at retirement age--pensions, social security, medicare--and for them an annuity structure makes good sense.  For someone who wants to escape the rat race earlier than that--especially those who want to escape it much earlier--it's important to be very careful about this sort of thing.  People do live into and beyond their 90s, and you wouldn't want to bet too much of your future on the idea that you'll die young.  A fairly small screw-up in calculating--or even just ordinary bad luck--can result in someone "retiring" early and then running out of money.

The steps to avoid such an outcome aren't hard:  Have a bit of margin for error.  Track your spending and your level of capital.  Make mid-course adjustments in spending if your capital starts to fall.

Most important--and this is kind of the whole point I'm making--the most powerful step you can take is to continue to earn some money during your "retirement."  Nothing will protect your core capital like being able to cover some of your expenses with earnings rather than investment income, and nothing will protect your capacity for future earned income like an ongoing history of earning money.

Thought-provoking as always. The early edition of "YMOYL" assumed 6-10% guaranteed returns via government bonds, rates that have not been available for a long time.

Wouldn't being able to earn through retirement be as much of a "gamble" as assuming investment returns will be what you need? Many of the jobs that retirees can get are the same deadening jobs that new workers can get. Not everyone can be a consultant at a high hourly rate. And very few can be freelance writers!

@Frugalscholar:

Sure.  But it's not a new gamble--you're already "gambling" that you can go on earning enough to support yourself with your regular job.

Granted, giving up a perfectly good job can seem like taking an extra risk, but the correct response to that is not to clutch ever more tightly to that one job, but rather to expand your range of options--more capital, more skills, more willingness to consider other options, more flexibility in the cost structure of your household.

One job that most people can take on is general living and householding skills. This is a fact because most people used to have these skills which are now largely forgotten or ignored. This does not mean stepping everything back in time. For instance, buying your own paper is clearly more cost-efficient than making it yourself as is doing large loads of laundry which used to be an all-day job or even sewing your own clothes. Other things, like repairing broken things or making home-chemicals have a huge return on investment, an "hourly wage" or more precisely, hourly savings rate that is far in excess of what most people are making. It is essentially a drive towards self-sufficiency, but obviously self-sufficiency has diminishing returns and nobody should aim to be 100% self-sufficient unless they are very rich in time.

@ Early Retirement Extreme:

On the topic of self-sufficiency, I've written a whole post:  Self-sufficiency, self-reliance, and freedom.  The alternative to self-sufficiency is trade, and the upside to trade is significant:  If you specialize in whatever you do best, and then trade with other people for the things you need, everyone has a higher standard of living.  (If you do the math it's literally true--everyone is better off, not just the people who are especially good at whatever they specialize in.)

As with most things, I'm inclined toward a middle ground.  I want a higher standard of living than I can get on a self-sufficient basis, but I don't want my life to depend on the economy continuing to function smoothly day in and day out.  I want to have some capacity to be self-sufficient in a pinch.

Just as I think everyone should have a medium-term goal of having enough capital to support their bare-bones budget, I think it would make good sense for everyone to have a medium-term goal of developing the skills and acquiring the means to fend for themselves at some level, against the possibility of hard times.

This is also why I think there are many reasons, besides frugality, to do for yourself.

I encourage knowing how much you need to live on (or how much you are currently living on). I did it using Quicken, but one can use any tool that works for them. Knowing that number allows one to examine and make smart choices from a position of knowledge (invest, train, make your own pasta ;-)). Too many folks have no idea where they spend their money.

Quicken Is A Great Project Management Tool

I bailed out of the rat race on a one year sabbatical (unpaid, no job return guarantee) with the hope of not having to go back to the corporate world. The economy decided to help out by nose diving and my company chipped in by eliminating any job to go back to.

I'm currently busy honing my consulting and writing skills (the latter not in Phil's class). My goal is self sufficiency, which means not needing to live off my capital. I'm open to any interesting salaried job opportunities for example, but I no longer need a salary. I did buy my way out of the rat race, but that just gives me the flexibility to run my own race.

Hi Phil,

Don't race with rats! I like that. We have some similar thinking, and that's why I wrote "Knowing When To Walk Away - Financial Planning For An Unknown Future where I essentially recommend choosing an AGE target, and not a monetary target for freedom.

Most folks don't LOVE their job, but I would say most find it bearable and can even like their jobs.

Thanks for sharing.

Keigu,

Financial Samurai
"Slicing Through Money's Mysteries"

Yes, It's good to start investing as early as possible to come out of rat race. I like your advice "learn how to do, make, grow, and find things for yourself". This helps to overcome economic downturn and provide security for lifetime :)