One of the biggest questions people have is “How much do I need to retire?”. This is especially true for people looking for an early retirement (aka FIRE). Many people will say this has been answered with the four percent rule.
What is the rule?
Developed in the mid-1990s, the four percent rule attempts to establish a “safe withdrawal rate” based on historical data. What it says is that with a 60% stock and 40% treasury bond allocation (some say it’s 50/50), you can safely withdraw 4% of your portfolio every year. After the first year, you’ll need to adjust up and down for inflation.
This model portfolio has been tested over numerous periods of economic prosperity and turmoil. Historically, this approach has shown that you could be fairly confident that you could spend at the inflation adjusted 4% every year for about 30 years and not have your money run out.
Therefore, to calculate how much you need to save, you could simply ask “How much do I want to spend every year?”. Of course you know this number, since you checked out our budgeting post.
Doing the math
Let’s say you need $40,000 per year – this means that you need a million dollars ($40,000/.04 = $1,000,000). It’s simple to calculate, just divide your annual spending by .04.
There are lively debates around this, partly due to the currently lower than average interest rates. Some will say you should be conservative and use three percent and others say five percent is just fine.
Which you choose will be up to your particular situation and risk tolerance, but it’s at least a good starting point. You now have an idea of what ballpark you should be in.
Live long and prosper (but not too long)
Roughly speaking, men will live to about 75 and women to about 80 in the United States. Remember however, that the 4% rule is only geared for about 30 years worth of retirement. To follow this rule, you’ll likely need to hold off until at least 45-50 to retire. Of course we all know people who have lived much longer. You should also account for the fact that people are likely to live longer and longer, as you age, due to medical advances.
A longer retirement means more risk. It’s just the facts. The longer you need your money to last, the more bad things that happen to work against you. To my knowledge there is no “4% rule for FIRE” investors. A safe withdrawal rate for a longer retirement would certainly need to be lower. It is 2%, 3%, I’m not sure. Maybe that is a research topic for another day.
A different perspective
My personal philosophy is a bit different. The 4% rule is based on continually selling your assets. I prefer to create a portfolio of investments that will meet my spending needs indefinitely. This means that in theory, I will never sell an asset to raise cash. I also want this portfolio to grow that income stream to at least meet the rate of inflation.
We’ll dive into how to construct that portfolio in an upcoming post. Check back often.