Fundamentals of Early Retirement – Part 2

How Much Money Do I Need to Retire?

In Part 1 of our Fundamentals of Early Retirement series, we learned the power of reducing our monthly cost of living.

Slashing our monthly cost of living creates margin between our income and our expenses so we can save money, destroy debt, invest, and build wealth.

Today, in Part 2, we’re going to explore the confusing and often strange world of figuring out how much money you’ll need to retire.

You’ve likely seen lots of companies talking about how retirement is a number and not an age.

But finding out your number isn’t a hard science, which is why you’ll likely find a lot of retirement calculators with wildly different answers to this question.

Calculating How Much You Need for Early Retirement

When it comes to estimating how much you’ll need to retire, most of us in the Financial Independence community use a guideline called The 4% Rule.

In short, this guideline states that we need a nest egg of around 25 times our annual estimated expenses in order to be able to retire.

So if our annual expenses are $100,000, then we need about 25 times that amount saved up, or $2.5 million to retire.

Because this is based on expenses, reducing our monthly cost of living, and thereby our annual expenses, actually reduces our total amount needed to retire.

How Much Money You’ll Need To Retire Based on The 4% Rule

As we can see, the lower our annual expenses, the lower our retirement number.

That’s Different Than What Some Retirement Calculator on the Internet Said

I have no doubt.

Many retirement calculators on the Internet are based on your salary, which is only relevant if you spend every penny you make, in which case you’ll never be able to retire anyway, so those calculators are completely worthless.

Some calculators make you guess how much you think you’ll spend in retirement, which is a nice parlor trick, but the information is only as good as the source.

If you don’t know how much you’re spending right now and last year and the year before that, good luck guessing what you’ll spend 3 years or 5 years or 10 years into retirement.

But since you’ve been doing a budget and tracking your expenses for a few years, you have actual numbers that prove how much your current lifestyle costs.

These are real numbers we can work with to find out how much we’ll need to retire.

How Does The 4% Rule Work?

In 1998, three professors from Trinity University conducted a research study in which they used historical market data to analyze various retirement portfolios and see how they performed over a 30-year period starting in 1926 all the way through 1995.

They focused on how different withdrawal rates and portfolio allocations affected the longevity of the nest egg.

The study found that portfolios made up of 50% large-cap stocks and 50% long-term corporate bonds were able to survive 95% of all 30-year periods between 1926 and 1995 when only 4% of the total portfolio was withdrawn each year.

Let’s Look at a Quick Example

Based on this 4% withdraw rate, if we have an investment portfolio of $1,000,000, then we can withdraw 4% of that portfolio each year, that is $40,000, and we will have a 95% chance of our money lasting for the next 30 years.

Tip: You can easily find your nest egg amount by multiplying your annual expense need by 25. ($40,000 x 25 = $1,000,000)

In this example, after year one, we’ve reduced our portfolio by $40,000 so we have $960,000 remaining.

After year two, we’ve reduced our portfolio by another $40,000, so we have $920,000 remaining.

Hmmm…it doesn’t look like $1,000,000 is really going to last for 30 years at this rate.

You’re right!

That’s because the simple math above is based on the money being stuffed under our mattress or sitting in a savings account, both of which are very poor places to store $1 million dollars.

The 4% rule only works as designed if we have our portfolio invested in the market. The Trinity Study accounted for the market returns over each 30-year period, allowing compound interest to play its magical role.

In fact, we’ll likely have many years where our portfolio will gain more money in interest than we’ll need to withdraw, meaning our portfolio has the opportunity to continue to grow even after we’re retired.

Don’t Forget About Inflation

Inflation in the US has historically been about 3% a year.

That means every year, our money buys about 3% less than it could the year before.

In short, things become more expensive over time.

This is why your dad used to be able to buy a Coke for a nickel and today it’s $2.50.

Luckily, the Trinity Study accounted for this inflation in their 4% withdrawal rate, so that 95% success rate is still intact.

But we need to account for it in our withdrawals as well.

If a retiree is going to live on $40,000 a year for 30 years, we need to understand that $40,000 today will buy a lot more stuff than $40,000 30 years from now.

So we’ll need to increase our annual withdrawals by 3% each year to maintain that same $40,000 of purchasing power over time.

In year one of retirement, we withdraw $40,000 from our nest egg.

But in year two, we need to withdraw $40,000 + 3% to account for inflation. Three percent of $40,000 is $1,200, so in year two we will withdraw $41,200.

In year 3 we will withdraw $41,200 + 3%. Three percent of $41,200 is $1,236, so in year 3 we’re withdrawing $42,436.

And so on.

This is an important consideration that is often overlooked. We need to make sure that we are just as able to buy things in year 23 of retirement as we are in year 3. A static withdrawal of $40,000 every year won’t accomplish that goal.

Don’t Early Retiree’s Need Their Money to Last Longer Than 30 Years?

Absolutely!

If we retire at age 40, we’ll likely have another 40 or 50 years on this earth. Running out of money in year 30 is NOT the goal!

But there’s good news. Early retirees have a couple of financial benefits that more traditional retirees might not.

1. We can engage in other pleasurable activities and hobbies that just might make us more money.

In fact, most early retirees do. Very few of us just sit around and watch Netflix all day and eat ice cream. That’s a horrible retirement, but a great way to die well before our money runs out.

And these pursuits don’t have to make a lot of money to significantly extend our retirement portfolio.

Every dollar we earn is a dollar we don’t have to remove from our nest egg, and every dollar in our nest egg grows us even more dollars through compound interest.

2. We can adjust our living expenses as the market fluctuates.

We don’t have to withdraw 4% from our nest egg every year. In fact, we probably shouldn’t.

If the market goes into a severe slump, we should definitely consider dropping our withdrawal rate to 3.5% or 3%.

In fact, remember that 95% success rate from the Trinity Study? In the 5% of cases where portfolios failed to last 30 years, it was due to a continued 4% withdrawal rate at the start of retirement just as a market downturn started.

This is truly a worst-case scenario, but by simply reducing our withdraw rate even by just 1% we can avoid this failure scenario. We simply have to be flexible.

3. We have more time to allow our money to grow.

This may seem obvious, but by starting our retirement 10 or 15 years earlier, we have more flexibility around when we withdraw our money. We are better positioned to wait out a few bad years in the market than a more traditional retiree who may feel the need to spend money now before it’s too late.

When we retire at 40, we’re making a calculated guess that we’ll be just as able to do things at age 50, so there’s no rush to do everything right now.

A 65-year-old retiree might not have the same hopes for their 75-year-old self.

These 3 advantages of early retirement allow us to take the mental leap from a study that proves out portfolios to 30 years, and take that knowledge and build our own portfolios and lifestyles that we believe can last 40 or 50 years or longer.

Retirement will only ever be as flexible as we are, regardless of our age.

Conclusion – You Need About 25 Times Your Expenses to Retire

How much you need for early retirement is truly unique to everyone, but in general, we can assume that 25 times our annual expenses is a good number to start with.

Some people feel like they need more…so they save more.

Some people feel like they are just fine with less…so they take the leap with less.

The most important thing is to know yourself, know your spending, and know how flexible you are willing to be in your retirement.

Now that we have an idea of how much money we’re going to need to have socked away, where exactly should we…uh…sock it?

In Part 3 of our Fundamentals of Early Retirement series we’ll look at the Extreme Early Retirement Account that Everyone Should Know About, and why this account is a great place to start storing up money.

Thoughts From Others:

You Will Die Before You Run Out of Money – by Jeremy at gocurrycracker.com

Safe Withdrawal Rate for Early Retirees – by Brandon at madfientist.com

How Much is Enough – by Bryce at millennial-revolution.com