You worked hard all your life at your job. Maybe you worked in an air-conditioned office or maybe you worked in a coal mine. It doesn’t matter, you served your time, and some day you will no longer be able to go to work every day.
Fortunately, you were a disciplined saver and investor, and you have accumulated a sizable nest egg. You have, haven’t you? But how do you know if what you have is enough?
Step 1. Estimate a Retirement Budget
The first step is to determine the amount of spending you are likely to have once you are retired. If you are not already doing so, you should begin tracking your monthly expenses. Do this for at least a year. Include federal, state and local taxes in your budget.
Once you know where all your money is going, you can come up with a budget for when you are retired. This should be a monthly or annual amount amount. Let’s suppose it is $5000 per month or $60,000 per year.
Step 2. Determine Income Cashflows
Next, determine all you income cashflows. This would include income from social security, income from pensions, income from Single-Payment Fixed Annuities (SPIAs), and any other monthly or annual income streams that are perpetual. Let’s suppose all these added together come to $1000 per month or $12,000 per year.
Step 3. Determine Cashflow Needed from Your Nestegg
Subtract the Cash Inflows in Step 2 from the Cash Outflows in Step 1. In our example, that would be $60,000 minus $12,000 equals $48,000 per year, or $4,000 per month. This is the amount of money that will need to withdraw from you portfolio.
Step 4. Apply 4% Rule.
The conventional wisdom for how much you can withdraw from your portfolio is embodied in the so-called 4% rule. This rule says that if you withdraw an inflation-adjusted 4% per year, a portfolio is likely to last for 30 years. It should be stressed that this is just a simple rule of thumb for doing rough calculations.
The inverse of 4% is 25, so this means that your nestegg needs to be at least 25x your annual spending. In our example, where the annual spending is $48,000, the 4% rule or 25x rule would give a required portfolio of 1.2 million dollars.
The Trinity Study and the 4% Rule
The 4% rule comes from the so-called Trinity Study. Researchers at Trinity University in San Antonio, Texas looked into withdrawal rates in retirement. In 1998, they published a paper titled Sustainable Withdrawal Rates in Retirement. The authors were Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz.
You can download the original paper here You should become familiar with this before you begin retirement.
In the paper, look at Table 2. Portfolio Success Rate with Inflation-Adjusted Withdrawals: 1926 to 1997 on page 5. Notice that with 75% Stocks/25% Bonds, at a 4% annual withdrawal, the success rate was 100% for 20, 25 and 30 years. This is the source of the 4% Rule.
How Did They Get 4%?
To better understand the meaning of the 4% rule, look at the chart below. This chart shows the Maximum Withdrawal Rate (MWR) for each of fifty-five 30-year periods starting in 1926 until 1980. Observe that the MWR has varied from 4% to about 8%. The period 1966-1996 had the lowest MWR of 4%. That’s the 4% rate reported by the Trinity study and it’s a worst case number. It’s the minimum of all the maximums.
The chart stops at 1980 because that’s the last complete 30-year period that we have in 2010. It is always possible that some other 30-year period we haven’t seen yet will have a lower MWR than 4%.
Shortcomings of The 4% Rule
Since the paper was published, the 4% Rule has become the conventional wisdom. It is referenced in personal finance books and articles, used by financial planners, and recommended by mutual funds companies like Vanguard. But recently it has received a lot of criticism as being too simplistic. For one thing, the paper only covered the U.S. stock market over a limited period from 1926 to 1997. And S&P 500 stocks and Corporate Bonds were the only investments in the mix. Many retirement portfolios have a wider selection of assets like value stocks, small cap stocks, government bonds, inflation-indexed bonds, CDs, real estate, gold, etc.
Also, many retirees face a retirement period longer than 30 years–40 or 50 years is not unusual for an early retiree or anyone downsized out of a career at age 50. Further, not many retirees are willing to take on the risk of owning 75% stocks. A more likely stock allocation for retirees might be 25 to 50 percent. Some people are not comfortable owning any stock.
How About a 3% Rule?
Going back to Table 2. in the paper, observe that at 3% inflation-adjusted withdrawal rate, the success rate was 100% for almost all the cases. Using a 3% rule would provide a greater margin of safety, albeit at a reduced level of consumption. In our example, $48,000 spending would require a nest egg of 1.6 million dollars.
The main problem with the 4% rule is not with the rule itself, but in how people have interpreted it. Some planners call it the “safe withdrawal rate” which is very misleading. The reality is that the 4% Rule, or 25x Rule, is only suitable for rough planning purposes before retirement to set a target to aim for. Once you are in retirement, more detailed analysis is called for, including mid-course corrections when things don’t turn out as planned.
Use the 4% rule While Accumulating
Getting back to the original question, “How much is needed to retire?” just follow steps 1,2,3 and apply the 4% or 25x rule to the amount of cashflow you will need from your portfolio. That should be your minimum goal for planning purposes while you are working and building your nest egg.
When retirement is imminent, a more detailed analysis is in order. I’ll write about that in a future article.
The views expressed in this article are those of the author and do not necessarily represent the views of Laguna Beach Bikini, its editors, staff or any other organization.
