In the William Danko and late Thomas Stanley classic The Millionaire Next Door, the authors talk about two different types of people who handle their money in ways that either lead to wealth over the long term or lead to mediocrity or poverty. These are Under Accumulators of Wealth (UAWs) and Prodigious Accumulators of Wealth (PAWs). UAWs are likely to always stay in the lower and middle classes, while PAWs, even if they start out in a disadvantaged financial position, are likely to move into the upper class at some point in their lifetime.
The Classic Millionaire Next Door Approach
The original formula laid out in page 13 of The Millionaire Next Door takes into account two variables to determine this classification: age and income. It is as follows:
Multiply your age times your realized pretax annual household income from all sources except inheritances. Divide by ten. This, less any inherited wealth, is what your net worth should be.
In order to be considered a PAW, your net worth should be twice the expected level. To be considered a UAW, your net worth would be half the expected level. In short, this is:
PAW if Expected Net Worth > 2*(Age*Income)/10
UAW if Expected Net Worth < 0.5*(Age*Income)/10
This a good starting place to determine whether you are truly on the path to becoming wealthy. However, it doesn’t really take into account all of the right variables. I mean, what if you are 22 years old, have been working for a year, and are absolutely killing it making $100,000/year? Is your net worth really supposed to be $220,000? News flash – you’ve only been working for one year, your net worth might be negative because of student loans.
The Arebelspy “Normal” Approach
Essentially, time to accumulate wealth is factored in linearly, when it really should be considered exponentially. Fortunately, someone has come up with something better.
Arebelspy, one of the administrators on the MMM forums, suggests an exponential formula for tracking how “on track” one is to building wealth, measured against an aggressive but doable benchmark. Formula number one is:
Expected Net Worth = (EXP(0.075*(Age-20))-1)*Income
This is a lot more reasonable, as it has lower expectations for wealth building in the early years, but exponentially increases as one gets older. Let’s take a look at an example of someone who starts out at 20 years old and makes $35,000 per year, which isn’t unreasonable for a variety of entry level positions. We’ll assume their pay increases by 3% per year, so the amount they should have in expected net worth correlates with their increase in income over time. The graph below shows a comparison between the arebelspy formula and Dr. Stanley’s.
This seems pretty reasonable. You can get to that level of wealth by contributing $925 per month over a 45 year period with a 7% investment return. Or, if your returns were a little better, say 8%, you’d only have to contribute $675 per month. Don’t get me wrong, this would definitely be a lot in the early days – if you’re making $35,000 per year pre-tax we’re talking about $11,100 per year in savings for the 7% scenario and $8,100 per year in savings for the 8% scenario.
Assuming an effective tax rate of 15%, this equates to a 37% and 27% savings rates on net income, respectively. This is definitely more than the norm, but it is also doable. This is even more so if you look ten years out in both of these hypothetical scenarios. At 30 years old, let’s say your income compounded at 3% per year since you were 20, so now you’re making a little over $47,000 per year. Now, using the same assumption for taxes, and the investment amounts, you’d only need to be saving 27% or 20% of your net income to hit $3,350,000 by age 65.
Basically, if you can save about 25% of your net income throughout your working lifetime, you’re golden. You’d be able to retire comfortably within about 30 years (assuming a 4% withdrawal rate). Your assets wouldn’t have to grow very aggressively, at a 7% or 8% long term rate of return.
What about if you are truly a hardcore saver though? What if you consider yourself a Mustachian, and saving 50% of your net income is what you consider normal?
The Arebelspy “Hardcore Mustachian” Approach
Arebelspy offers a more aggressive formula for this type of person. It essentially doubles the exponential rate of growth that is expected for a person at a given age and income level:
Expected Net Worth = (EXP(0.15*(Age-20))-1)*Income
Now is where things get interesting. What does this data look like? Let’s first look at the initial 30 years of a Mustachian’s working life. Note that here, I’m assuming that the person in question earns an income and invests for 45 consecutive years, although I am well aware that many (the majority?) of Mustachians seek early retirement as their goal and actually plan to not work once they hit their “number.”
Here there’s a dramatic difference in expected net worth. By the age of 50, the formula tells us that our hypothetical hard-core saver should have over $7,500,000 in investments. Whoa! Initially, I crunched these numbers with the same income and rate of return assumptions – $35,000 per year at age 20 and 3% raises thereafter. I looked at an 8% long term rate of return.
It didn’t really add up, because even if you saved 50% of your income throughout this period, there’s no way you would hit $7.5 million with these assumptions. Let’s say at 30 years old, you’re making $47,000 pre-tax, like before. Let’s say you were saving 50% of the after-tax amount, or about $1,660 per month. This would already be pretty difficult, as you would be living on $1,660 per month as well. Additionally, this is far less than the $5,150 per month required to hit $7.5 million at an 8% rate of return.
Ok, so assuming that the variables of time, salary and age are not altered, a higher rate of return on one’s overall portfolio would need to be responsible for this kind of growth. To be fair, in the thread where this topic was thoroughly discussed, arebelspy admits that the formula works best for the first 15 years of compounding and for someone with a 50-75% savings rate. In our example, at 35 years old the expected net worth for a Mustachian saver is a little bit over $460,000. This equates to about $1300 invested per month consistently over that 15 year period, with an 8% rate of return – definitely reasonable based on our assumptions of someone who is a hard-core saver. In the beginning of one’s career, that’s a 52% savings rate, while at age 35 that’s a 39% savings rate (again, accounting for taxes and a 3% annual rise in salary).
From that point, in order to go from $460,000 to $7,500,000 between ages 35 to 50, it would take $17,250 per month (!) to hit that number with 8% annual compounding.
Ok, so this model works great for the first 15 years on one’s working life for hard-core savers. What would work well over a longer period of time though? How would I do it?
The Old Man Mase Approach
I think that standard milestones to shoot for should be based mainly on two things: savings rate and rate of return of one’s investments. These parameters should both be somewhat aggressive, but yet conservative enough that they are actually achievable.
I’ve chosen two scenarios – a “standard Mustachian” approach and a “hardcore Mustachian” approach. For the standard approach, I’m assuming:
- 50% savings rate
- 8% growth in investments annually
- 3% growth in salary annually
The most difficult part of that scenario is probably the savings rate. It can be hard to get to saving 50% of your income, especially if you start out not making very much. However, once your income increases a bit and get a few expenses under control (including probably eliminating debt), there becomes enough margin to get to that 50% mark.
For more hardcore Mustachians, saving 60%+ is possible with discipline (or with a very high income without a lot of discipline, ha!). For this scenario, I’m assuming:
- 60% savings rate
- 8% growth in investments annually
- 5% growth in salary annually
The 5% growth number for income increases is reasonable I think, with some concerted effort. I’m not saying that income increases would come in this scenario all at once, because we all know that this tends to happen in fits and starts. One year you get promoted, while the next couple of years you get cost-of-living raises (2 or 3%).
I used the future value of a growing annuity formula to come up with the values for expected net worth in both scenarios:
By tweaking two of the variables in just a small way, you can get way better results over time. Let’s look at the “Old Man Mase Milestones” for saving under these scenarios.
We see that with the Standard Mustachian approach it would not be unreasonable for someone starting out making $35,000 per year to reach age 65 as a decamillionaire. They’d be able to retire much sooner than 65 however, around the age of 37. Net worth around this point would be about $716,000. With a 4% withdrawal rate, they’d be able to live off of $28,640. This would cover all of their living expenses since they’d be making around $56,000 per year at the time, and living off of half of it. If you wanted a little bit more margin of safety at this point, you could just work three more years until age 40. At that point you’d be set for life with about a $1,000,000 portfolio that you could live off of (theoretically) forever.
With the Hardcore Mustachian approach, you’d reach $16,000,000 by 65, or 60% more wealth than the Standard Mustachian. You’d be a decamillionaire before hitting age 60, and able to retire at 35 or 36 (with a bigger margin of safety at around 38).
I think this form of an equation is reasonable because it accounts for all of the important variables: years working, savings rate, investment growth, and income growth. All of these numbers play a part in determining the ultimate outcome.
With that said, when people say things like, “it’s excusable if someone doesn’t retire a millionaire in America today”, I generally agree with them. Barring large unforeseen medical expenses, or other major negative life events, if someone is not able to save $1,000,000 over a 40 year career, they weren’t really trying.
Additionally, if someone who considers themselves Mustachian, and discovers the path to financial independence in their 20s does not have a massive net worth by the time they are 65, they weren’t really making an effort to put a lot of money away and/or putting it in bad/mediocre investments. Isn’t it amazing though that someone can amass so much wealth simply by saving 50% over their working lifetime? (I say “just” 50%, but I recognize this is a difficult feat if you haven’t yet been exposed to many of the strategies and tactics used to work toward financial independence.)
It’s still crazy to me, and it is a concept that will probably never get old. I’m still too young to be able to fully appreciate the power of compounding, but just looking at the math is really inspiring. To be a wealthy Mustachian (am I being redundant there?) all you have to do is pretty much save 50% of your income and keep working hard. Eventually you’ll get there. Further increases in income and investment returns can supercharge your results, but it’s not necessary to make crazy assumptions – and that’s what makes this whole financial independence thing so exciting – it’s actually attainable!