“Are we there yet?”
I think everyone has uttered these words as a child. Sometimes in anticipation when off to the movies, but generally as an unwilling passenger on the long trip to “that” relative. You know, the one! They have no other kids, a house full of “do not touch” objects and a
black and white TV that could only pick up one channel that seemed to forever only show the same episode of some boring drama from 20 years ago. As a side note for you younger folks, the concept of your own mobile device, let alone the internet was not even the stuff of science fiction so a black and white TV was still a thing!
Well, if you decide to embark on a FIRE journey, you first wonder when you might retire early. Then at some point (many points!) you will ask yourself “Are we there yet?” question. And if you are pursuing FIRE, the “there” is a number.
That wonderful amount of money that would mean that if you WANTED to, you could retire. Yes, I capitalised the word “WANTED”. But no, I was not shouting it (well maybe just a little), just emphasising it. Remember I am a FIDERman, the D being “Discretionary” (although temporarily it is delayed!).
A post about the misconception that FIRE is for people who want to retire and withdraw from society is for another day! This post is about trying to work out what that “number” is.
Use the 4% rule to calculate “your number”
I still remember where I was when someone put me on the spot and asked how much I would need to feel comfortable to retire right then. Without much thought I blurted out $3 million, before a slight pause and increasing it to $5 million. I am not sure what else we talked about that morning as I was suddenly struck by the realisation that even though I had been thinking (a lot!) about retiring early, I didn’t actually know what that magical number was. Let alone whether I could even get there!
“More” money obviously is better if you intend to live off it without having to work again. But “more” is not very specific. If my target was too high, then I would work for longer than I needed (or maybe forever!). But if it was too low then I would face a nasty shock at some point post retirement. I did not fancy waking up in cold sweats post retirement realising I would need to go back to work.
Surprisingly, my initial google searches were not promising. Mr Money Moustache had a great post about the simple maths of retirement. It essentially linked your savings as a percent of your salary to how long you needed to work before retiring. I also came across other articles that referenced needing 50-70% of your salary in retirement. However, these did not quite gel with me.
They were essentially about a retirement based on living off less each year than you currently earned (and likely spent) each year.
While there is nothing wrong with that, I intended to spend MORE in retirement than I did whilst working. I was happy to make some sacrifices whilst working to save money (as I at least realised that was essential). However, I didn’t see much point in retiring to do less of what I wanted to do despite having more time to do it!
There were some other articles that referenced specific amounts. $1 million seems to come up often, but I suspect that is as much because it is a nice easy number to remember rather than anything else.
However, I realised there was no single number that could ever be right for everyone, as it totally depends on what you want to do.
Then I came across the “4% Rule” – and a lightbulb went off (is it just me or do light bulbs seem to have all the good ideas?).
The 4% rule
A simple description of the 4% rule is:
With a given starting amount of money invested predominantly in shares you can live off 4% of that starting amount, adjusted each year for inflation, forever.
This means if you had a $1 million starting amount and you assumed inflation was 2% per annum (seems crazy high at present, but for most of my life people thought that was a crazy low assumption), you could spend $40,000 in year 1, $40,800 in year 2 (being $40,000 x 1.02), $41,616 in year 3 (being $40,000 x 1.02 x 1.02) and so on WITHOUT EVER RUNNING OUT OF MONEY!
Some people also call it the rule of “25x” or “25 times”. This is because with a bit of algebra (remember that from high school!) you can actually work out how much you need to save based on how much you want to spend.
Why the 4% rule is also the rule of 25x!
Time for some Fidermaths! Let’s write the 4% rule mathematically. We will use “Savings” as the amount of money we had saved and “Year 1 Spend” as the amount we could spend each year (before worrying about inflation) forever without running out of money it would be:
4% x Savings = Year 1 Spend
Now, you may also remember from school that 4% is 4 divided by 100. This can be written as “0.04”, so we can a now rewrite the equation as
0.04 x Savings = Year 1 Spend
Now just multiply both sides by 25 and we have
25 x 0.04 x Savings = (Year 1 Spend) x 25
But 25 x 0.04 = 1, and anything times 1 is just itself so we get
Savings = (Year 1 Spend) x 25
The beauty of this equation is that if we know what we intend to spend each year we can work out how much we need to save.
For example, if you wanted to spend $100,000 in year 1 and $102,000 in year 2 (using our 2% inflation assumption) etc, you would need
Savings = $100,000 x 25 = $2,500,000.
This formula gelled with me. It was simple, it factored in the lifestyle I wanted in retirement rather than what I was earning or spending right now. And it gave a target that was personal to me.
Many other bloggers have gone into detail on the history and the complex mathematics behind the 4% rule. Although I actually do love and understand that maths, I know I am in the minority. I suspect reading pages of equations and statistical analysis daunting and confusing rather than helpful for most people.
Rather I want to try to provide a staged and simplified look at the 4% rule. I think if you understand the 4% rule you will feel more comfortable in applying it, and adjusting it!
The 4% rule in action
Imagine you saved $1 million, expected to spend $40,000 next year to live the life you want and think inflation will be 2%. Suppose you also had the opportunity to invest in something that guaranteed you a 7% rate each year.
In finance lingo, the return of 7% is called the nominal return while the amount in excess of the 2% inflation, being 5%, is called the “real return”. For the super technical people, yes I know that with a 7% nominal return and a 2% inflation rate the actual real rate of return is 4.902% (being 1.07/1.02 -1) but the simple approximation is more than sufficient for this discussion.
In that case, post retirement life looks something this…
Day 1 of Year 1– You wake up but have no idea what time it is as you have thrown away all alarm clocks now that you have retired. After a few minutes revelling in your freedom before asking Siri for the actual time and opening your investment account. Knowing you need $40,000 to cover your spending, you take it out of the $1 million in savings and put it in a bank account earning no interest. Then you invest the remaining $960,000 at 7% and happily enjoy your year of retirement, spending all $40,000.
Day 1 of Year 2 – You wake up around some time past midday. Last night’s celebrations of your first year of retirement went very late – and realise your bank account is empty! Time for action! You need to move money from investments to your bank account. Given inflation is 2% you calculate you will need $40,800 (being $40,000 x 1.02) to get through the current year. Logging in to your investment account reveals the $960,000 has grown to $1,027,200 (being 1.07 x $960,000). You let out a satisfied whistle. Even with the money you took out at the start of the year, you have ended the year with more than the $1 million you retired with. You transfer $40,800 and reinvest the remaining $986,400.
Side Bar: Notice that the amount transferred out, $40,800, is NOT calculated 4% of the amount in the investment account. While 4% of $1,027,200 is $41,088 which is close to $40,800 this is coincidental. The “4%” in the “4% rule” is to determine the year 1 spend. In subsequent years, inflation affects how much you need to take out to spend and you can actually forget about the “4%” altogether!
Day 1 of Year 3 – You wake up to your 8am alarm and curse that resolution to get up early and get in shape! Again you realise your bank account is empty. Going through the same process as before, you log in to withdraw the new increased amount of $41,616 (being $40,800 x 1.02) to cover the coming year’s spend. As you do so, you notice your investment account is sitting at $1,055,448. Even after taking out the $41,616 you still have in excess of $1 million left to invest.
Can you see the pattern? You are not going to run out of money no matter how long you live. In fact, when you start your 10th year of retirement you would find that your investment account is $1,287,737. This is even though you have withdrawn and spent $390,185 in the previous 9 years!!!!
Problem solved – NOT!
Now, I know what you are thinking. Surely, it can’t be that easy. No, it is not (and don’t call me Shirley!).
There are in fact many complications and consideration, far too many for one post – hence why this is Part 1!
For now we will look at just adjusting some assumptions before later dealing with complexities of the real world.
So, let’s see what happens if we earned a 6% nominal return (the same as a 4% real return) instead of a 7% nominal return. Whilst you would have less to invest at the end of each year, you still wouldn’t run out of money. Amazingly your investment balance continues to grow faster than the amount you withdraw!
However, if we could only get a 5% nominal return (so a 3% real return) then what? Bad news! You would run out of money. It won’t happen overnight, but it will happen – in a little over 43 years.
OK, so what if our inflation assumption was wrong and instead of it being 2% it was only 1%. This is obviously good for us! The amount we need to spend each year goes up slower, leaving more money to be invested.
Under a 1% inflation assumption, even earning 5% (so a real return of 4%) means we never run out of money. Remember, with inflation of 2% and a nominal return of 5% we ran out of money at round 43 year. That was because in that case our real return was only 3%.
If inflation was 1%, then a real return of 3% implies a nominal return of 4% (being 1% plus 3%). In that case we would also run out of money. Interestingly it would also occur at around the same time.
Do you notice that amazingly, both graphs look very similar irrespective of whether inflation is 1% or 2%. You may think they are same at first glance, but look closely and you will see the numbers are different. In a 2% inflation world and a 5% real return (7% nominal return) we have more than $6 million after 50 years. But in the 1% inflation world a 5% real return (and so a 6% nominal return) we “only” ended up with a little over $4 million .
Whether our investment account runs out of money, stays fairly steady, or grows massively is mostly dependant on the real return.
So obviously if we want to use this rule our investments need to earn real returns of at least 4%.
Welcome to the jungle
The bad news is that it is impossible to get a guaranteed future real return of 4% on your investments for ever.
But there is good news! You can, over a long period, be highly confident you can achieve the returns required to use the 4% rule. The even better news is you can do this without being a qualified financial analyst, or even a wannabe superhero.
However, to do this you will need to take a journey into the jungle aka “The investment world”.
If you think spending your spare time fighting villains like Thanos, the Green Goblin or Mysterio is daunting, wait until you try to enter the “investment world”. A world where people in shiny suits, and even shinier teeth, will talk in a seemingly foreign language trying to convince you this is a world you cannot explore on your own. They will tell you this world requires their assistance, but your money.
Well, never fear, FIDERman is here! But that adventure is for Part 2 …..
Great explanation of the 4% rule, v useful thanks