This sounds too easy to be true, right? Wrong- it actually is that easy. Just save 25 times your yearly expenses and you will be prepared to retire. Once you are retired, you will live off of 4% of your nest egg each year in retirement.
How does 25X yearly expenses and 4%/year relate? It’s simple math divide 1 Year by 25 and you get 4%.
If you have yearly expenses of $40k/year, you will need $1M to retire ($40k x 25).
Where did the 4% rule come from?
The 4% rule was published by financial advisor William P Begen in his 1994 paper “Determining Withdrawal Rates Using Historical Data“. Based on historical data, he discovered that retirees could safely live off of 4%/year (adjusting for inflation/deflation each year).
Why 4%? Why not 3% or 5%?
To answer this question, let’s look at the different scenarios he tested.
Bengen tested portfolios invested in 50% S&P 500 Funds (stocks) and 50% Bonds and he used this assumption to test a range of withdrawal rates. He looked at a 50 year historical range and tested each year as the starting year.
- 6% withdrawal rate
- 40 scenarios had the money last less than 40 years
- 10 scenarios had the money last 50 years
- 5% withdrawal rate
- 23 scenarios had the money last less than 40 years
- 19 scenarios had the money last 50 years
- The remaining scenarios lasted between 40-50 years
- 4% withdrawal rate
- Only 5 scenarios had the money run out in less than 40 years.
- Most scenarios had money left into 50 years of retirement.
- 3% withdrawal rate
- All scernarios lasted 50 years.
It is worth noting that a 75% stock / 25% bond allocation actually improved that withdrawal rate scenarios. Begen recommends investing as close to 75/25 stock/bond as possible.
So why isn’t this the 3% rule?
Clearly 3% is a safest withdraw rate. 4% is very safe, in most cases the money lasts 40 Years or more. If there is a recession – will you reduce your withdrawal rate? Will you go back to work part time? Reducing your withdrawal rate for a few years would have a great impact of extending the time before your money runs out, the study showed.
I personally have a target much greater than 25X our current yearly expenses, that is due to Mrs. Free Runner and I planning for 2-4 children (and paying for college), wanting to have extra spending money, a better sense of financial security, and to leave an inheritance to our children. Our goal is to save $2.5M in 14 years which would put us at about 63X our current yearly expense (I know way overkill).
However, it is nice to know that we can retire even earlier if we need too. Using the Financial Free Runner Retire Early Calculator, we could retire in 8 years with $1M, or 14 years with $2.5M (assuming 7% average rate of return).
What if you save more than 25x your yearly expenses?
Well, that’s awesome! Way to go you! If all things are the same, then you will have a withdrawal rate of less than 4%.
If I use my example of $40k yearly expense and save 30x of the yearly expense, I will have $1.2M. If I withdraw $40k per year, that will only be 3.3%.
Will your money run out?
Whether you choose a 3% or 4% withdrawal rate, your money will likely never run out. Let’s say you achieve an average rate of return of a conservative 7%, and inflation equates to an average of 3% per year and you withdraw 3%, your money will actually grow by about 1%.
How does this post change your goals?
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