This is the million-dollar question. A lot of advice has been written on the subject and so to avoid beating a dead horse the answer to how much you need to retire on is it depends. Everyone has different life circumstances, different levels of income, and different retirement goals. For example, if you’ve reduced your expenses to the bare essentials and only have yourself to take care of your goals will look different than wanting to travel the world and retire by age 40 with your spouse. And again this looks different if you have kids and is dependant on which country you live in. However, there are two rules to abide by to have a rough idea of how much you need to retire and then you can adjust accordingly. These are the 4% and Multiply by 25 rules.
The 4% Rule
The 4% rule states that you can safely withdraw 4% of your savings annually without reducing your principal, adjusting each withdrawal afterward by inflation. This rule was created using historical data on stock and bond returns over a 50 year period between 1926 and 1976 when the publication of a 1998 paper titled Retirement Savings: Choosing a Withdrawal Rate that is Sustainable, often referred to as the Trinity Study, was published. It was named so because the three professors that published it worked at Trinity University. The study has subsequentially been updated to 2009 under the paper Portfolio Success Rates: Where to Draw the Line published in 2011. Their conclusion did not change. The 4% rule works.
There are skeptics of the 4% rule. Namely that you should be even more conservative and withdraw 2% or 3% because historical returns are not predictive of future results. However, to put things into perspective the updated study between 1926 and 2009 encompassed the following crises:
- First World War
- Great Depression
- Spanish Flu that killed over 100 million people
- Second World War
- Multiple recessions
- Korean War
- Vietnam War
- Cold War
- Gulf Wars
- 1990’s Tech Bubble
- The Financial Crisis
Some of these events felt like the end of the world scenarios and yet the stock market still went up over time. How did the 4% rule fare? Majority of the time it worked. Furthermore, Warren Buffett predicts that the U.S. stock market will experience 7% returns in the future (down from the historical 10%). If you assume 3% inflation per year, that means your investments will earn 4% real returns. If your investment is increasing by 4% real returns and you withdraw 4%, you still have your principal. Makes sense.
Let’s say for example you saved up $1,000,000 for retirement. This means using the 4% rule you can safely withdraw $40,000 per year. In ten years, assuming 2% inflation per year, you would be withdrawing $48,760 per year adjusted for inflation. Simple right? That’s the beauty of the 4% rule. However, there are a few caveats.
Limitations of the 4% Rule
The 4% rule assumes a 50/50 stock and bond portfolio split. If you’re young this is overly conservative. In the updated study, Portfolio Success Rates: Where to Draw the Line, they found that a portfolio split of 75% stocks and 25% bonds outperformed the 50/50 portfolio split and successfully supported a 30-year retirement with a 5% withdrawal rate through 82% of the sample overlapping periods. Using the previous example that means you could safely withdraw $50,000, adjusting for inflation, on a $1,000,000 portfolio every year.
The 4% Rule ignores a few other variables:
- The studies do not incorporate mutual fund fees. Mutual funds are dead; I recommend investing in index funds instead which increases your withdrawal rate by paying lower fees.
- The study was performed in the U.S. and doesn’t hold up as well in other developed market countries. This is why I recommend investing in the U.S. stock market as it has outperformed every other in the world. Think of your favorite companies in the world, chances are they are headquartered in the U.S.
- The study considers retirement lengths of up to 30 years. If you plan on retiring early (before 65) you could very well live in retirement beyond 30 years. And if you live in the U.S. and retire before the age of 65 you will need private health insurance which costs on average $7,188 for single coverage and $20,576 for family coverage, equivalent to $599 to $1,715 per month that will need to be budgeted for before Medicare kicks in, assuming you meet the qualifications.
- There’s no guarantee that historical results will be replicated in the future. While this is true, see below.
On the flip-side it also doesn’t consider:
- You will likely adapt your withdrawal rates over time. For example, you are likely to be more active and travel more when you are younger vs. when you are 80. Your withdrawal rates will likely go down over time.
- It ignores other sources of retirement income. For example, pensions, rental properties, Social Security (or the Canadian Pension Plan), and any other types of income that may result from working in retirement (side hustles anyone?). This can be substantial.
- The ability to move to a country with lower costs of living and lower health care costs. This can help mitigate the costs of having private insurance if you decide to retire early.
- You can adjust your spending rate to compensate for price increases. Spending is a controllable variable.
- Depending on where you live you may have medical coverage. This saves you from having to get private health insurance or having to travel to another country for medical coverage.
Multiply by 25 Rule
This is a variation of the 4% rule, but instead of withdrawing money, the Multiply by 25 Rule estimates how much money you’ll need to have in your retirement portfolio when you’re ready to retire based on your target spending rate. What is your spending rate?
Your spending rate = spending / after-tax income
Take all your expenses and divide it by your after-tax income and that is your spending rate.
For example, if your spending rate is $50,000 per year, using the Multiply by 25 Rule means you will need $1,250,000 saved up. Each year you would withdraw the amount that you plan on spending. Saving up a portfolio of this size is easily achievable for most people if you save and invest early and often.
Which is Better to Follow?
Both rules work equally well and come to the same conclusion.
However, between the 4% Rule and the Multiply by 25 Rule, I prefer thinking of my retirement using the Multiply by 25 Rule. Why? You have much more control over your spending. While I am a big advocate of negotiating your salary, negotiating raises, trying to get a promotion, and increasing your income using side hustles, these opportunities either come rarely or take a lot of work and effort to pull off. In contrast, you have much more control over how much money you spend. Being proactive about your finances is the best way to meet your financial goals. To change your mindset from how much you need to save to how much you are spending is an important one.
How Do You Lower Your Spending Rate?
Adopt the 80/20 rule for your finances. This means focusing on 20% of your effort to get 80% of the results. The three biggest expenses to focus on for the largest financial gains are:
- Reducing your housing cost. Housing is the largest monthly expense for most people and it’s not even close. If you can reduce this by having a roommate, living at home for a while, or living a little further away from work (but not too far since the fuel and maintenance costs can add up, not to mention you will be happier if you live closer to work) can all help. I realize this can be hard in some cities like New York so try your best.
- Reducing your travel cost. I lived in the suburbs for years to pay off my debts and save up my down payments. While this is contradictory to my advice here, my savings were so substantial it was worth it for me. I’ve since moved closer to work and my travel costs have been reduced to $0. Most likely you can find a balance between distance and cost by taking the bus, train, or biking to work. Studies have shown a 15-minute commute is the best for your happiness.
- Reducing your food cost. This one might be the hardest habit to kick. I used to eat out every day for lunch for the convenience factor and to get out of the office. Add up coffees and meal delivery services and some people are spending over $40 a day on food. Multiply that by 20 business days in the month and that’s $800 on food not including weekends. If you have a family this can even be more. I’m not one to say skip the lattes or avocado toast (you need to live your life!) but be more conscious about eating out. I meal prep on Sundays and usually save eating out for Fridays as a reward for meeting my weekly food budget. I’ve also cut back on my coffees from two a day to drinking office coffee in the morning and then treating myself to one in the afternoon. These small tweaks add up over time.
The 4% and Multiply by 25 rules come to the same conclusion. Are they perfect? No. But they can be used as a solid starting point to achieve your retirement goals. Whatever the critics say, these rules are conservative and are proven to work over the biggest crashes in the stock market’s history. However, each person is different and has different goals and as such these rules should be adjusted accordingly.
Legal Disclaimer: The views expressed by Mr. Dumont on Money Sensei are solely his and not intended as investment advice nor a guarantee of any financial return. Mr. Dumont is not an investment or tax professional, so the information contained on the blog is not a substitute for professional advice. The contents of this blog are accurate to the best of his knowledge at the time of posting, but rules and laws are ever-changing. Please do your research to confirm that you have the current information.