How much do you need to Retire?
It’s time to get our heads out of the clouds and back to cold hard numbers. This is the first of a series of posts where I’ll lay out the exact details of our plan for financial independence in less than two years. First question – how much do you need to be financial independent?
All the various financial independence/early retirement sites talk about a very simple rule of thumb called ‘the 4% rule’. This is referred to as a ‘Sustainable Withdrawal Rate’ (SWR). Essentially, it’s the amount you can safely withdraw from your portfolio every year. It’s set so you can be relatively certain that you will not run out of money and end up eating cat food on your 70th birthday. Simple!
Where does the 4% rule come from?
The 4% rule comes from one paper (and one update to that paper) performed by several professors at Trinity university – hence why it’s often called The Trinity Study. Using historic returns of the US stock and bond markets and a range of withdrawal rates, they assessed the performance of sample portfolios starting in every year since 1926. The chart below is from their study and contains the little gem that everyone talks about.
The horizontal axis is the assumed rate of withdrawal in year one. They started with a $1,000 portfolio, so 4% would be $40 in the first year. They then adjusted that $40 every year to match inflation over the entire period.
The vertical axis is two elements. The first is the composition of the portfolio as a mix between stocks and bonds, ranging from all stocks to all bonds. The second is the time horizon of the test, from 15 years to 30 years. Basically, how aggressive were you with your investments and how long did you live.
The key finding is at the intersection of a 4% withdrawal rate, 75% Stocks/25% bonds, and 30 years. That 100% means that from 1926 until 1979 – as long as you started at the 4% withdrawal rate and only adjusted your spending for inflation – you could have retired in any year and never run out of money over 30 years. From 1929 before the great depression to the stalled market of the 70’s and 80’s, your retirement would have been safe.
Another way to visualize this is below. The graph lays out all the maximum possible SWRs for every year since 1926. For example, if you retired in 1929 you could withdraw 5% without running out. If you retired in 1981 you could withdraw 8.5%. That red dot is the minimum of the entire history – if you retired in 1966 you could have only withdrawn 4%.
But What if I retire early? I’ll be living for longer than 30 years!
Hopefully! The short answer is that over a sufficiently long enough period of time if the test portfolios didn’t fail in 30 years they likely would not fail over any time horizon. The more complicated answer involves looking at what typically happened to those test portfolios over time. The chart below is from the same Trinity Study.
It shows something profound and very powerful. The table shows the median ending portfolio value. Each portfolio started with $1000. The median for our 4% withdraw, 30 year, 75% stock/25% bond portfolio is $6000, nearly 6x our starting value! Even when we were withdrawing every year, our wealth still grew significantly!
Why is this? The highlighted portion of the table below explains a lot of it.
The long run total real return of the stock market was 7%, well above our 4% withdrawal. Let’s take a 100% stock portfolio worth $1000 as an example. You start out by withdrawing $40 in year one. However, at the same time, your portfolio is delivering you $70 in gains. In year two you then start with $1030. You withdraw $41 (adjusting for 2% inflation), but your portfolio returns you $72. In year 3 you start with $1061. Carry that forward thirty years and you end up with a big pile of money.
How do we know the 4% rule will hold in the future?
The honest answer is that we don’t, but there are a few very good economic reasons why I think it will. And also some practical reasons why I don’t think it matters. First, the reasons why I think it will hold.
- The growth of developing countries – While the world has hit a bit of a rough patch over the last few years, we should not discount what has actually happened. 1 Billion people have been lifted out of poverty and we’re set to do the same thing again. That’s billions of new minds that will be thinking up the next wave of innovations that will drive growth around the world. The present is actually pretty bright and it will only get better!
- Massive Productivity Improvements Everywhere – We are rapidly entering another era of dramatic change. Change that will bring massive productivity increases across the global economy. Some may be fearful, but I see it as an opportunity for humanity. There is a very good chance that the world of tomorrow may be one of hyper-abundance rather than scarcity.
And now why it doesn’t matter if it doesn’t hold entirely. The Trinity Study assumes two things that almost certainly won’t be true for any intelligent and motivated person:
- You will never earn another penny. I can guarantee that this will not be the case for my wife and I. We’re already dreaming up stuff to do. Some of those things will, unfortunately, make us money!
- You won’t adjust your spending. The trinity study assumes an ignorant dolt who couldn’t figure out that during a major recession it might be a good idea to cut back a little. We won’t do that.
- You won’t find or have access to anything that returns a higher rate than the SP 500. The obvious call out here is real-estate income investing, that can return in excess of 10% rates if you’re savvy.
So what does all this mean?
The takeaway is simple. When you can live off of 4% of your invested assets you’re done. Finished. Out of the rat race. You never have to work another day in your life and you will be just fine. If you have 25x your families annual spending you have hit your target.That’s freedom staring you in the face.
- Jonathan below brought up a good point on inflation adjustments for longer term time horizons than my wife and I. If you’re still a long way off from retirement your ‘target’ amount for how much you need should be adjusted for inflation. You’ll need 25x the amount you plan to spend annually during retirement. The trinity study takes inflation into account, but it’s based on starting your retirement immediately. So if you planning on retiring in 10 years you should assume that your annual spending might be a bit higher 10 years from now. However, if you’re like my wife and I, your actual spending even with inflation will probably be much LOWER. But if you’re already at the bleeding edge of frugality, a good rule of thumb for inflation is 2-3% per year. So if you’re retiring in 10 years you’ll need 25 x Spending This Year * (1.02)^10.