Capital Substitutes for Labor — and Vice Versa
Whether you're hoping to retire early or worried that you won't be able to retire at all, this is something you need to understand. (See also: Can You Buy Your Way Out of the Rat Race?)
Did you know there used to be a return on capital? Sorry, a little joke there. With interest rates down near zero, it's starting to seem like a safe income on capital is an old-fashioned concept. Dividend rates had been low for some time — meaning that even the risky income was low — and then the stock market lost 40%, wiping out a couple decades of that low income. All in all, it's been a bad few years for income from capital.
It used to be easy. You could talk about the 4% rule, which said if you had a diversified portfolio, you could spend 4% of your capital this year — and increase that spending with inflation — and reasonably expect that your portfolio to grow enough to keep up.
Even though the 4% rule is looking a little iffy, I think the principle remains sound. At some ratio, capital substitutes for income from labor, and vice versa. For planning purposes, I think 4% is as good a ratio as any.
If that's the right ratio, you need about $25 of capital to support every $1 of spending that you're not going to earn from your labor (because 4% of $25 is $1).
On the one hand, this calculation can be pretty discouraging. If you see retirement age bearing down on you like an express train and your retirement savings has barely reached five figures...well, a $10,000 portfolio can be expected to support annual spending of around $400. Not the sort of dream retirement that most people had in mind when they first started putting money in their 401(k).
In fact, the reality is much brighter, because the calculation also works in reverse.
Let's say that your financial advisor has told you that, to supplement what you're expecting from social security (and maybe a pension, if you're getting one), you need to have retirement savings of $X. And let's further say that you're coming up short. And not just a little short. Let's finally say that even if you work a few extra years and save as hard as you can, you're going to be short by $100,000.
There's going to be a gap, and using the 4% rule, we can estimate just how big that gap will be. In this case, the gap is going to be $4,000 a year.
My point here is that filling a $4,000 gap isn't so very hard. One option would be to earn that much money. Another option would be to cut spending by that much. Neither option will be what you'd expected when you made your retirement plan, but neither option is necessarily a great burden. Lots of people choose to work in retirement. Lots of people find that they need to cut back on spending to stretch their retirement savings.
Of course, there's every option in between — for every $100 you can cut spending, that's $100 you don't need to earn in retirement.
There's nothing new in these tradeoffs — you're already making them. Every economic decision you make has its roots in this sort of thinking: Which college to go to (indeed whether to go to college), which jobs to apply for (and which job offers to accept), where to live, what car to buy (or whether to go car-free), how often to eat out, how often to eat rice and beans, what brand of coffee to buy.
The key takeaway here is that you can, within rough limits, make long-term plans based on these tradeoffs.
Without this tool, if your financial advisor (or some retirement planning website) tells you you need to triple your contributions to your 401(k), or else you're not going to be able to retire, you have no idea what that really means.
With this tool, you can make a good, albeit inexact calculation. For each $1,000 you don't save, your spending in retirement will have to fall by about $40 a year.
It is, of course, entirely up to you how you act on that insight. Maybe looking at an impoverished retirement will inspire a bit of frugality now. Maybe you'll try to work extra hours or find a second job. Maybe you'll look to a new career that pays better — or a new career with better options for continuing to earn some money in retirement.
Do remember that it's just a rough calculation. The return on capital is so low right now, anyone spending 4% of their capital this year is probably spending at unsustainable levels. The 4% rule is a planning tool, not a guarantee — but it's a very useful planning tool.
Knowing how you can swap labor for capital or capital for labor can help you design your life to meet your goals.