My daydreams about retirement have evolved over the years. When I was younger I thought retirement meant spending most of the day on the fairways and the afternoons at the 19th hole. Or maybe trolling the waters of a big lake in a nice fishing boat sharing stories with an also-retired friend. So saving for retirement was centered around these same activities.
Photo courtesy of danperry.com
When I got a little older my dreams graduated to a grand retirement played out in an expensive condo on the beach, or a million-dollar cabin in the mountains. After I got a job, got married, and had two kids I quickly realized this idea of a luxurious retirement was not very realistic. My early ideas were shaped more by the movies than the real world.
Now that I’m a “thirty-something” (and old enough to remember the television show by the same name), my dreams for retirement are more centered around spending time with family. I’d like to do a little traveling (nothing glamorous, and mostly domestic), and spend some time working with young people by either coaching or teaching, or some combination. While my retirement plans are still a little vague, I am certain that I do not want to still be working in the corporate world in my old age.
To make my dream of financial independence a reality, I need to put a number on it, and devise a plan to hit that number in a reasonable amount of time. Lots of theories out there on how to calculate your “number,” and depending on the formula used there is some fluctuation in the amount required. However, this is a case where being in the same ballpark is close enough for me, so I don’t overly concern myself with the math.
The 4% Rule
To demonstrate the 4% rule I’ll use a fictitious 30 year-old worker named Dan. Dan works as a software engineer by day, and builds decks and fences on the weekends. He earns $80,000 a year for his combined efforts. Ideally, Dan would like to reach financial independence at 50 years-old and spend his time modifying homes for those with disabilities – things like building wheelchair ramps, widening doorways, and similar accessibility features. The service would represent a combination of his love for carpentry and a call to service Dan has wanted to fulfill his entire life. What kind of nest egg would Dan need to pull this off?
The rule of 4% uses a couple assumptions, some of which are hard to justify in our current market conditions. In a typical market, it is not unreasonable to expect a 10%-12% annual return on a portfolio of stock market investments. That means you can safely withdraw 4% of your portfolio each year and not reduce your principal balance, even after accounting for inflation.
Anything earned above the 4% withdrawal and the rate of inflation grows your balance even higher (with the idea that you may have to increase withdrawals later to cover increased medical costs, insurance premiums, etc. as you get older).
To figure out the number required to maintain your current style of living, divide your current income by a factor of 0.04. In Dan’s case, maintaining an $80,000 yearly income would require a $2 million nest egg. But Dan is a frugal guy, and he and his wife plan to pay off the mortgage early – in their early 40’s. They buy older, used cars and trucks with cash, and have managed to pay off credit cards they ran up in their twenties. They could easily live on $50,000 a year.
Running the formula again reveals Dan would only need $1.25 million to become financially independent. He could withdraw a guaranteed $50,000 a year, or in years where his new business earned money he may not have to touch the nest egg at all.
Is 4% Too Much To Expect?
As I mentioned, the 4% formula uses some long-held assumptions about investments that may or may not be true in the coming decade. I personally look for things to turn around in the next two years, but that doesn’t mean we’ll see a repeat of the “irrational exuberance” of the last 90s in the market. I think going forward investors will slowly have their confidence restored, but because it will take some time we can probably expect lower rates of return than in previous periods.
I also expect inflation to rise at a faster pace in the next few years. Actually, I expect currency deflation to occur, but the net result is the same – future dollars will be worth much less than they are today. The rise in inflation, coupled with lower expected yields from the market, mean it might be asking too much to expect to withdraw 4% from your nest egg without lowering your principal.
So What’s My Number?
My lifestyle lines up pretty well with Dan in that I hope to be living completely debt free by 50 – no credit cards, no car loans, and no mortgage. If I can get to that point, my lifestyle needs will be fairly basic, and we could live very comfortably on $40,000-$50,000 per year (in fact, we could probably live on much less, but I’m being conservative here).
Reducing my expected withdrawal rate to 2-3% means I would need between $1.5 million and $2 million to live comfortably on $40,000-$50,000 a year. I’ll split the difference and make my goal for financial independence $1.75 million. Looks like I’ll need a few more side hustles.