Ahh the question that every working person wants to know. Or perhaps it’s a question that some working people haven’t even thought about because early retirement seems unattainable – they just assume they’ll work 8 hours a day, 5 days a week, 52 weeks a year, give or take, until they reach the ripe old age of 65 or so and retire to “the good life.” Well let this post be the starting point to your research for the answer to this deep, mysterious question.
When asking this question about retirement, it is important to understand what retirement really means to you. For me, it doesn’t necessarily mean a hammock between two palm trees on a sunny beach with a beer in hand. Nor does it mean having all the money in the world to buy each model of the Tesla lineup. More simply, retirement means freedom. Freedom to do what I want, when I want, however I choose. Freedom to spend time with my family. It means I’m no longer a part of the rat race, no longer required to depend on a paycheck. Does it mean I’ll no longer work? Most certainly not, I will continue to strive to contribute to society, but on my own terms. I will find my own outlets for hard work and creativity, my own passion projects, my own ways to help others and better the community. I guess you can say I will no longer “work” in the traditional sense, but I will most definitely still be working hard. Most likely with plenty of travel excursions to rejuvenate from the hard work that comes with retirement.
Keeping in mind that retirement doesn’t necessarily mean absolute zero active income, it is important to realize that how much you need to retire doesn’t depend on your current income at all. It doesn’t matter if you’re making $20k a year or $300k a year. Instead, it depends largely on your current spending and savings rate.
Current spending gives you a ballpark figure for how much you will need for retirement. Not accounting for inflation, if you spend $1 annually now, you most likely will spend $1 per year in retirement, so you should be able to easily retire for 50 years on a $50 retirement savings nest egg. If you spend $100,000 yearly now, you most likely will maintain your $100,000 per year lifestyle in retirement, so you’ll either need a $5million retirement savings nest egg (it will be much more when you factor in inflation), or your intended 50 year retirement will be cut short and you’ll be back slaving away in no time. It’s important to understand this because there is no reason for the $1/year spender to save up a $1million retirement nest egg, the same way it’s silly for the big spender to think a $2million retirement nest egg will last 50 years. Don’t forget when looking at these generic, simple examples, we aren’t looking at the passive income being generated by the retirement nest egg. Your nest egg won’t just be sitting in a bank or under your mattress, they will be invested in low-fee Vanguard index funds.
With current spending covered, let’s take a look at savings rate. Savings rate gives you a ballpark timeframe to reach retirement. My mind was blown when I finally grasped the concept of savings rate as it relates to retirement. For math simplicity, say a person makes $100 a year. If he saves $10 a year and spends $90 that year (10% savings rate), he will have to work 9 years total to have saved enough for 1 year of retirement, assuming the $90 annual spending remains constant. If another person also makes $100 a year, but she saves $50 and spends $50 each year (50% savings rate), she will only need to work 1 year total to have enough for 1 year of retirement! Isn’t that crazy?! Let’s get more extreme. Say a third person embraces the frugal lifestyle, and has an 80% savings rate. By saving $80 and only spending $20 each year, after only working 1 year, she will have enough to last her 4 years with no additional income! Insane! This is the magic of having a high savings rate, no matter what your income level is. Most people find themselves somewhere in-between the super frugal and the super extravagant, but still, what’s the magic formula to determine how much you need to retire??
The 4% Rule
The answer lies in the 4% rule: 4% of your retirement savings needs to be able to sustain your spending for a year. Or more simply:
how much you need to retire = annual spending x 25
So for example, if you currently spend $40,000 annually, you will need $1,000,000 to retire. If you’re about 30 years old like me, you might be wondering how will $1million sustain a $40,000 per year, 60+ year retirement? The magic lies in the stock market, your low-fee Vanguard index funds, and compound interest. To look at it simply: the historical rate of return for stock market is 7%. Take away 2-3% to account for inflation, we get 4% to be on the safe side.
The 4% rule is pretty well known in the FIRE community. This rule originates from a 1994 paper by William Bengen, a retired financial adviser. This rule was further popularized thanks to a 1998 paper by 3 professors of finance at Trinity University – this study became known as the Trinity Study. In the study, Bengen analyzed the historical returns of the stock market between 1925 to 1995. Looking at 30-year periods (1925-1954, 1926-1955, 1027-1956, and so on), he used various scenarios calculating different withdrawal rates from a retirement nest egg, invested in a mix of 50% stocks and 50% bonds. Keep in mind this time period includes some of the hardest times such as the 1929 stock market crash leading to the Great Depression, the 1987 stock market crash on Black Monday, as well as World War II and the Vietnam war, to name a few. What he found was worst case scenario for lasting 30 years, a 1966 retiree could withdraw 4.15% at most, and still have his retirement nest egg sustain him for the entire 30 year retirement period. That is, he can withdraw 4.15% of his retirement investments annually, and still have money leftover after 30 years. This became known as the 4% rule. An interesting note – the 1966 fellow presents the worse case scenario of a successful 30 year retirement. In some scenarios during other 30 year periods, the retiree actually ended up with a larger nest egg than when he first retired!
The 4% Guideline
I view the 4% rule as more of a guideline, nothing concrete. This is important because many variables can come into play in 30+ years of retirement. The data from the Trinity Study looks at a 50% stocks, 50% bonds asset allocation, but allows variation up to 75% stocks, 25% bonds. More stocks mean you can have a more aggressive passive income stream, but it will be more volatile. Since we will be early retirees, we can afford to be more aggressive. As a retired 40 something year old, I would be able to return to the rat race (part-time?) if my aggressive portfolio takes a plunge. I would not be as willing if I were a retired 60 something year old, so a less aggressive portfolio would make more sense. Stock markets always go up and down, so if a down year presents itself, common sense would say you adjust your 4% withdrawal rate lower. The Trinity Study also doesn’t account for any extra income from any side hustles you will have in retirement (remember your passion projects, side business, rental properties, etc?). Also when you get old and wrinkly, Social Security may still be around for a nice bonus each month. Investment fees aren’t accounted for, which is why it is ever so important to use the low-fee Vanguard index funds (0.04% for VTSAX!). And taxes. What about the damn taxes? Well, you can’t escape them. The good thing is that once you are retired, you most likely will be at your lowest income bracket since the majority of your “income” will be what you withdraw from your investments.
So there you have it. You have the formula to mathematically set your retirement goal. Are you a worry wart? The numbers can be flexible. Perhaps your goal amount will be your annual spending x 30. Or maybe your safe withdrawal rate is 3.5% from the get-go instead of 4%. You have the tools and the knowledge now, use it!
What are your thoughts on the 4% guideline? How happy are you with your savings rate? How does your magic retirement amount compare to what you previously thought? Are you getting excited yet?!
Featured Image Photo Credit: Cork Creative