How Much Money Do I Need to Retire? The 4% Rule

This article covers two of the major topics. First, let me introduce this 4% rule, upon which, I am willing to stake my entire retirement portfolio. And then, we will cover exactly how much money you need to retire according to “The Rule of Twenty-five.”

The 4% Rule

One of the most important cheat codes known to the refined financial independence community goes by a few names like: “The 4% Rule” or “The 4% Safe Withdrawal Rate.” abbreviated “SWR” or “SAFEMAX” or sometimes “The Trinity Study Rate.”

As with most fundamentals of finance, there is an endless comment section of debate and controversy around this topic. This actually works out in our favor since so much conversation, attention and energy has resulted in a lot of great studies and data for us to consider. It is also worth noting that the vast majority of the controversy is not about the effectiveness of the rule itself but rather about the exact fraction of a percent of this rule. Rather than splitting hairs, we will consider the perfect percent a personal preference.

Definition of the 4% Rule

For the sake of this article let’s define the Safe Withdrawal Rate as:

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The maximum percentage of retirement savings that you can spend per year, such that you never run out in your lifetime.

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Before we calculate this rate for your situation we need to consider a few variables.

We all know that the stock market is a rollercoaster ride as it reacts to various economic forces such as; gross domestic product (GDP), interest rates, unemployment rates, housing demand, consumer confidence, inflation, and fear/irrational exuberance of future valuations, etc.

At first glance this seems like too communicated an equation to solve. I mean depending on how inflation continues we don’t know if the price of a gallon of milk will be $6 or $60 dollars when you are 65.

The good news is that several financial Jedi Masters have gone before us and already figured this out for a bunch of portfolio mixes across the historic stock market performance data and figured out what the maximum safe withdrawal rate is to not run out of money in retirement.

It turns out that if you withdrawal not more than 4% of you stash each year your money will last through retirement. Thus, the money needed to retire is 25 times your annual expenses according to “The Rule of Twenty-five” which we will derive in a minute. If that is not simple enough, let me point out that all of the economic variables listed above are factored into these two rules, as we will now unpack.

The Origin of the 4% Rule

Before the age of “big data” financial expert lore postulated that 5 percent was a reasonable amount for retirees to withdraw each year. Back then you couldn’t just type a question into google, wait 0.025 seconds and see a list for 375,000 answers to your question. Back in the day you had to do a ‘study’ to get an accurate answer.

One financial advisor named William P. Bengen, did just that. In 1994 he published the results of a study “Determining Withdrawal Rates Using Historical Data” which analyzed historical data on stock and bond returns over a fifty–year period from 1926 to 1976. Bengen’s study concluded that a 4 percent withdrawal rate was more successful than prior findings. Bengen also found that no historical data existed in which a 4 percent withdrawal rate could exhaust a portfolio in less than 33 years.

The Trinity Study

In 1998 an influential paper was published by three professors of finance at Trinity University. The authors backtested a number of ratios of stock and bond portfolios and different withdrawal rates against market data compiled by Ibbotson Associates covering the period from 1925 to 1995.

The 4% Rule refers to one of the scenarios examined by the authors where 4% of the portfolio withdrawn during the first year for a hypothetical retiree’s living expenses. Then an ever-increasing portion was withdrawn in each following year based on the consumer price index (CPI) in order to keep pace with inflation. They gave this imaginary retiree a mixture of 50% stocks and 50% 5-year US government bonds, to represent a common traditional asset allocation (or a mixture of different investments.)

In the analysis this hypothetical person spent 30 years in retirement between the years 1925-1955. Then 1926-1956, 1927-1957, and so on. This massive analysis produced some fascinating results now known as the Trinity Study.

In 2010 the results were updated to include data through 2009 by a rather smart fella named Dr. Wade Pfau, Ph.D., CFA. He created the following very useful chart showing what the maximum safe withdrawal rate would have been for various retirement years:

As you can see, the 4% value is actually the worst-case scenario in the 65 year period covered in the study. Wade worked out that you can actually spend 6.54% and preserve your entire initial balance after 30 years. Thus, anything lower than a 6.54% annual withdrawal rate and you will accumulate a growing surplus in your portfolio as the years stretch on.

Just in case you are not fully comforted by now let me slap you with the stiff palm of reality. You have a better chance of dying in a car accident on the way to cash a retirement distribution check than actually running out of money in retirement. But for the pessimistic Pams out there, let me add some reassurance whip cream to the top of your portfolio pie.

The study concluded that for level payouts:

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“If history is any guide for the future, then withdrawal rates of 3% and 4% are extremely unlikely to exhaust any portfolio of stocks and bonds during any of the payout periods shown in Table 1. In those cases, portfolio success seems close to being assured.” For payouts increasing to keep pace with inflation, they stated that “withdrawal rates of 3% to 4% continue to produce high portfolio success rates for stock-dominated portfolios.”

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Ok that should be enough data to saturate the doubts of the most cautions of minds. Now you can rest more comfortable than a sleepy eyed kitten in a plush fleece blanket laying in front of the warm amber glow of a crackling FIRE.

Considerations of Criticism

Now before you thrash your keyboards with a thousand angry finger strokes to fill the comments section with complications why this will not work, let me make a few more points.

30 Years, So What! What about 70+ Years of Retirement?

“Mr. Refined! I am a 20 something-year-old student of your site who has been diligently reading your blog and living by the gospel of saving rate. I am going to retire in my 20’s and am preparing for a 70+ year retirement thanks in part to a generous increase in life expectancy. How does 70+ years affect this math?”

While it is true that Prudential calculates that the first person (in modern times) who will live to 150 years old has already been born. That does not spell doom and gloom for your portfolio.

First, the Trinity Study defines “success” as not going broke during a 30-year test period. To people like you and me who are much more refined than the hamsters filling the ever-spinning wheels of corporate America, we will enjoy 70+ year retirements. We refined folks certainly would not consider 30 years a successful retirement.

Luckily, the math in this case, is pretty interesting: there is very little difference between a 30-year period, and an infinite period, when determining how long your money will last. Imagine underpaying a credit card balance by $50 a month. You have just turned a 20 year repayment into a thousand year repayment! However, if you increase the payment by just $50 over the minimum payment and you can cut the repayment down to just 10 years. In other words, a fraction of a percent decrease in the rate of portfolio withdrawal and the remaining balance grows perpetually like a wet snowball rolling down a mountain.

Remember that ‘perpetual money-making machine’ I mentioned? It turns out that it is marginally (a fraction of a percent) different to manage an ever-increasing portfolio in early retirement as compared to managing a portfolio that depletes slowly over 30 years. So there is really no reason to avoid setting up your retirement portfolio as a perpetual money-making machine, whereby, your money never runs out and your quality of life can slowly increase over time with no additional effort on your behalf.

How Much Money Do I Need to Retire?

Why Most Online Retirement Calculators are Wrong

Read any random financial forum thread, Reddit or traditional retirement article and you will see financial neophytes (about 95% of the population) irrationally postulate retirements needs of 2-10+ million dollars. Unrefined, traditional financial advisors and the vast majority of online calculators are just as unreasonable at determining your retirement needs.

The problem is that these approaches depend on your pre-retirement income, with the implicit assumption that you spend almost all of what you earn. They often regurgitate values between 2-10+ million dollars, further reinforcing the paranoia of internet doomsayers. Now that we know how much money is needed each year in retirement, we can solve for total money needed to be ready for retirement. We simply take the inverse of the four percent rule and get…..

How to Correct the Madness: The Rule of Twenty-five

Fortunately we are much more refined than those knuckle dragging financial neophytes of the bronze age. Luckily, the math works out to be elegantly simple. Take your annual spending, and multiply it by somewhere between 20 and 30. That’s it! That is your retirement number. If you use the number 25 like me, you’re implicitly using a 4% Safe Withdrawal Rate.

The Simple Math of Your Early Retirement Number

Many people in the FIRE community use The Rule of Twenty-five to determine the amount of investments they need to retire.

Say you’re comfortable using a 4% safe withdrawal rate after reading the analysis above.

4% expressed as a decimal is 0.04

1/0.04 = 25 => The inverse of 4% is 25

Annual Expenses in Retirement x 25 = Portfolio Needs

For example, say also that after cutting a few things from your household expenses, your annual expenses are $40,000 per year (note what we are not using in this calculation …your income.)

25 x $40,000 = $1,000,000

A household spending $40,000 per year needs $1,000,000 invested to retire.

Your exact number should adjust based on your desired expenses and comfort level. For those retiring in their late 20s and early 30s, they should consider aiming for a lower withdrawal rate as the probability of success is loosely proportional to the amount of time they need their funds to last. It is especially true if you expect to never work again. Pensions are also not very common anymore, and social security is being depleted faster than its being replenished so they were not even considered for the sake of this article. If you have those benefits consider them cream on top of the pie.

Want Greater Precision and Confidence?

If you are a highly refined math-a-magician and are interested in the details of more refined calculations than shown here, I recommend spending some time at FIRECalc changing specific inputs to calculate more accurate numbers for your specific situation. FIRECalc offers a statistical approach (more accurate approach) to solve for the potential performance of any given portfolio. This site is impressively customizable for your specific situation.

Customizing Your Number

Fat FIRE

efers to an individual with a more traditional lifestyle who saves more than the average retirement investor or wants a step up in lavish lifestyle in retirement. Say they intend to join the local yacht club or golf club when they retire.

1/0.03 = 33.333      =>     The inverse of 3% is ~33.3

(1/.03) x $40,000 = 33.3333 x $40,000 = $1,333,333

Lean FIRE

Refers to more stringent adherence to minimalist living or dedicate savings, necessitating a more frugal lifestyle or later-earned freelance income. This is a great option for someone who wants to retire as fast as possible. You don’t have to retire here but you are prepared for an economic downturn, new boss, cooperate merger/sellout or relocation. The utility of “lean fire” gives you control of your life by not relying on corporate America for a paycheck to cover your living expenses.

1/0.05 = 20      =>      The inverse of 5% is 20

(1/.05) x $40,000 = 20 x $40,000 = $800,000

“Sure-FIRE” Plan – help me coin this term!!

Sure-FIRE means perpetual growth allowing a low-stress life and increasing quality of life. At this point, you will have the difficult decision of which beach to lounge on while you sip out of a coconut as you grow increasingly richer. No stress required if you are early in your career, you may 70+ years to experiment with different beaches around the world that offer Piña Coladas with your favorite colored mini umbrella’s. Once at FI, simply work an extra year or two, or save for an extra 1/2% withdraw rate.

1/0.035 = 28.5714          =>          The inverse of 3.5% is ~28.6

(1/.035) x $40,000 = 28.6 x $40,000 = $1,142,857

Of course for all of these calculations you will need to plug in your personal annual expense. I just used $40,000 in the examples above.

A few other levels of FI worth mentioning are:

Barista FIRE

Refers to refined followers who have quit their traditional 9-to-5 job but are still employed in some form of part-time work to cover current expenses that would otherwise erode their retirement fund.

Coast FIRE

lso applies to refined followers who quite the traditional 9-5 job for a part-time job, or perhaps the just cut back on the hours at their current job. This is a popular option for people with school-aged children.

Conservative Assumptions

• You never collect a single dollar from social security or a pension plan.
• You never collect any inheritance from the passing of parents or other family members.
• In retirement, you never earn any more money through part-time work, hobbies or consulting and you have no passive income streams (yeah right!)
• You never adjust spending to account for economic variances like a massive recession and for example choose to vacation closer to home that year.
• You don’t do what most old people tend to do according to studies – spend less as they age (spending decreases 2-3% each year after 57-year-old.)
• You don’t get any better at investing as you age and remain pegged to average market returns.
  

However, if any of the above conditions do apply you will end up better off than the trinity study results.

So, now you know how much you need to save for retirement and how much you can withdrawal every year in retirement. You have already read how long it will take you to join me on the beach. That leaves only one question…. What is your favorite color mini umbrella in your colada coconut cup?

Keep the fire burning my friends.

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Disclaimer:  This site is for informational and entertainment purposes only and shall not be construed as investment, tax or legal advice or recommendations. Because of the nature of the interactive dialogue inherent in the format of this site, it is important for readers and listeners to understand that not all comments made will apply to them specifically. Nothing said shall be taken to be investment, tax or legal advice, nor shall statements on this site be considered an offer to buy or sell securities. Such advice is rendered solely on an individual basis and at times will require that the investor review a prospectus. You should seek advice for your specific situation from a certificated financial advisor, a certificated tax advisor and a licensed attorney. I don’t claim to be an expert. Most days, I don’t even claim to be an adult. I just want more friends to drink out of coconuts with me on the beach.