Below we share an excerpt from the book Just Keep Buying by Nick Maggiulli where he discusses and elaborates on when can you retire and how much finance would be needed to retire successfully.
Imagine you had a crystal ball that could tell you your financial future. A magical orb that knew all your spending and investment returns over the next several decades. With such a device, we could perfectly plan out when you could retire to match your spending needs with your retirement income over time.
Unfortunately, no such object exists. While we might be able to estimate your future spending based on your expected lifestyle in retirement, we have no idea what investment returns you will get nor how long you will live.
This is why the Nobel Laureate William Sharpe called retirement the “nastiest, hardest problem in finance.” If it were easy, there wouldn’t be an entire industry dedicated to helping people navigate this period of their lives.
Despite the difficulty of the problem, there are some simple rules you can use to determine when you can retire. One of the simplest is called The 4% Rule.
The 4% Rule
William Bengen was trying to figure out how much money retirees could withdraw from their portfolios each year without running out of money. In 1994 he published research that would revolutionize the financial planning world.
Bengen found that retirees throughout history could have withdrawn 4% of a 50/50 (stock/bond) portfolio annually for at least 30 years without running out of money. This was true despite the fact that the withdrawal amount grew by 3% each year to keep up with inflation.
Therefore, if someone had a $1 million investment portfolio, they would have been able to withdraw $40,000 in their first year, $41,200 in their second year, and so forth for at least 30 years before running out of money. In fact, running out of money while using the 4% rule has been historically unlikely. When expert financial planner Michael Kitces did an analysis of the 4% rule going back to 1870, he found that it, “quintupled wealth more often than depleting principal after 30 years.”
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But despite its overwhelming success, the 4% rule seems to be the limit when it comes to annual withdrawal rates. When Bengen tested a 5% withdrawal rate, he found that it was too high to consistently work throughout history. In some periods, the 5% withdrawal rate only gave retirees 20 years of income before running out of money. Since this result wasn’t acceptable, he suggested 4% as the highest safe withdrawal rate going forward, and it stuck.
The beauty of Bengen’s 4% rule was that it provided a simple solution to an otherwise complex problem. Figuring out how much you could spend during your first year of retirement was no longer a stressful decision, but an elementary calculation.
“When you have a low inflation environment, your withdrawals are also going up much more slowly. So, there’s an offset to the lower returns that you can’t ignore.”– William Bengen
More importantly, the rule could be used to figure out how much you would need to save for retirement in the first place. Given we know that you can spend 4% of your total retirement savings in your first year, then we know that:
• 4% × Total Savings = Annual Spending
Using a fraction instead of a percentage we get:
• 1/25 × Total Savings = Annual Spending
Multiply both sides by 25 to solve for Total Savings, and we get:
• Total Savings = 25 × Annual Spending
To follow the 4% rule, you would need to save 25 times your expected spending in your first year of retirement. When you’ve reached this total amount of savings, you can retire. This is why I used this guideline in chapter 5 when discussing how getting a raise can affect your retirement savings. It was the 4% rule in disguise all along.
Fortunately, you will probably need to save far less than 25 times your annual expenses to meet your retirement needs. Assuming you will get some sort of guaranteed income during retirement (for example from Social Security), then you only need to save 25 times your expected spending above this future income.
For example, if you plan to spend $4,000 a month in retirement and expect to receive $2,000 a month in Social Security benefits, then you only need to save enough to cover the excess $2,000 a month, or $24,000 a year.
We will call this your Annual Excess Spending.
Therefore, the equation to determine how much you need to save is:
• Total Savings = 25 × Annual Excess Spending
Using this rule means that you would need to save $600,000 in order to retire ($24,000 × 25). In your first year of retirement, you would withdraw the $24,000. In your second year you would increase your withdrawal amount by 3% to $24,720, and so forth.
Despite the simplicity of Bengen’s 4% rule, it does have its naysayers.
For example, one common argument against is that it was created at a time when yields on bonds and dividend yields on stocks were much higher than they are today. As a result, some financial professionals have suggested that the 4% rule doesn’t hold anymore.
Since yield is just the income you receive from a bond or stock over a given period of time if yields drop so does your income. So if you paid $1,000 for a bond with a 10% yield, you would receive $100 in income each year from it. However, if bonds are only paying a 1% yield, then the most income you could generate from a $1,000 investment is only $10 a year. The same logic holds for dividend yields on stocks as well.
While yields have fallen over time, Bengen argues that the 4% rule still holds. In an October 2020 episode of the Financial Advisor Success Podcast, he argued that the safe withdrawal rate has likely increased from 4% to 5% because inflation is lower today than it was in the past.
As he stated:
“When you have a low inflation environment, your withdrawals are also going up much more slowly. So, there’s an offset to the lower returns that you can’t ignore.”
If Bengen’s logic holds, then the 4% rule may still be the simplest way to answer the question, “When can you retire?”
However, as much as I like the 4% rule, it assumes that spending for retirees stays constant over time. When we look at the data, it suggests otherwise—spending declines as people get older.
Excerpt published with permission from HarperCollins India Publishers, and Nick Maggiulli.