As a former IT contractor for over 10 years, I’ve often heard people say how they’re afraid to become a contractor, even though they also say they envy being one. The main reason being the insecurity.
So, I see the biggest fear or obstacle for individuals to become a consultant or contractor is the “lack of steady income”. This ties directly to your savings and retirement. What am I going to live on at the end of my career?
A traditional job for the majority of people is their source of a steady income. It’s also their retirement savings through the company pension plan. But, how much value are you really getting from the company pension plan versus the opportunity for making more income as a consultant?
To address this, let’s start with the traditional worker seeking full-time employment. We will assume you are going to work for one or more companies that offer pension plans. You work for a total of 30 years to age 65 and contribute 7.5%. We’ll assume you have a salary of $75,000 per year. This is the average over your 30 years.
Retirement Formula for Full-time Employee
Your retirement formula might be something like: 1.5% x years of service x best 5 year salary average.
Let’s say your best 5 year salary average is $95,000, so the calculation will be: 0.015 x 30 x 95000 = $42,750 per year for the rest of your life.
This is how much you’ll get for the rest of your life. But, when you die, you won’t get any lump sum. This amount is high because we’re assuming you work at one company only. If you work for multiple companies over your 30 years, then we’ll assume the sum of your pensions is equivalent to the above calculation. That’s a generous calculation.
“Retirement Formula” for a Contractor / Consultant
Now, what would you have to do to earn the same amount as a contractor? Let’s start with calculating how much you’ll contribute at 7.5% of $75,000. (This is the average from my scenario above.) This equals $5,625. If you contribute this much for 30 years, you will have some new value based on the rate of return you earn on your contributions. This is an assumption you’re going to have to make up. If you’re an investor like myself and invest in stocks, you might assume 8%.
This is actually a conservative estimate since if you invest in three investments: XIU, XSP, XBB, it has earned over 10% over the last 30 years, the last time I saw the numbers several years ago.
It’s also conservative because as an IT contractor, you’ll probably earn more than $75k / year, especially over a 30 year period.
So, if you contribute $5,625 per year (at year end) for 30 years and earn 8%, and stop working at age 65, you’ll have over $637,000. Now we need to figure out is this $637,000 about equivalent to getting $42,750 per year for the rest of your life, as if you were an employee?
Let’s assume the maximum age you’ll live to is 120 years. The longer you live the more money you need to earn. So, I’m making this calculation very conservative because the probability of that happening is so small. Chances are you’ll pass away before the age of 120.
Let’s assume we can get 5% rate of return by investing in dividend paying investments. In that case we need $800,000 if we plan to withdraw $42,750 every year. This is the amount we need to earn at retirement as a contractor in order to give ourselves $42,750 per year for the rest of our lives (to age 120) assuming our investment pays 5%.
This means we need to contribute $7,070 over 30 years instead of $5,625 to end up with $800,000. That’s an extra $1,445 per year as a contractor compared to being an employee.
I know for me, that’s easily well worth being a contractor. And if you can save more than that $1,445, then that’s bonus money for you in retirement.
You can play around with these calculations by varying how many years you want to work or how much you want per year in retirement or your earnings per year, or other factors I used to calculate your retirement.
Feel free to post your comments below..