Deciding on how much money you will need to set aside to retire comfortably can be a very daunting task. Most people have no clear idea where to even begin, let alone deciding on that comfortable target number.
I have great news for you! Retirement planning is not as tricky as you might think. I have a proven formula that I will share with you that has stood the test of time for over 100 years, including through the great depression. What is this formula? It’s the 3% Rule.
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The goal is to build up a sizeable portfolio of assets. How large?
Well, it should be large enough to support your standard of living – and each person’s view of that standard will be completely unique. When I say to an amount that is large enough to support your standard of living, I’m referring to the interest or passive income, from your assets that should provide your yearly income that supports your standards.
Financially Independent, Retire Early (F.I.R.E)
I’d like to note that this concept has been embraced by the F.I.R.E movement. FIRE stands for Financially Independent, Retire Early. While I don’t condone this exact philosophy in life, I think it encourages some good ideas in terms of investments and how to reach your goals. The basic philosophy of FIRE is to minimize your spending, save substantial portions of your income, and invest your savings. If you do this correctly, then you can retire at a younger age.
FIRE promotes the idea of using the 4% Rule.
The easiest way to understand this rule is that:
During retirement – yearly expenses should not exceed 4% of your savings.
Using the 4% Rule, you can determine how much you need to save in your portfolio, before you can stop working. I know you’re thinking, “But wait, you said 3% – why is it now 4%, what’s going on?” Please continue.
Let’s say for example that you need $100,000 / year to cover your expenses and live the lifestyle of your choice in retirement. Then you must amass a portfolio of $2.5M. Another way to explain this concept is that your portfolio needs to be 25X your projected yearly retirement spending.
4% Rule Rationalization
Here’s the reasoning behind the 4% Rule.
Your portfolio is made up of well-diversified stocks such as the S&P 500 Index. This is the most commonly tracked index in financial markets. The S&P 500 has historically returned around 7% annually, plus 2% in dividends. This represents a 9% overall return.
If your annual expenses increase at 2% annually, which is roughly the rate of inflation, your portfolio, which is increasing at 9% annually, should have no issue covering your expenses indefinitely.
In theory, this means you should never run out of money.
Let’s elaborate on this in depth.
You made up your mind and decided to retire at the end of 2022 2. Your current yearly expenses are $150,000. You’ve even managed to accumulate a portfolio of $3.75M by learning and adhering to the 4% Rule.
You’ve been doing your research, you’re a smart investor and planner and have always had your 1 year of expenses in cash for emergency purposes. So, you decide to live on that the first year. Now at the end of 2023 your portfolio has grown by 7%, you have also earned 2% in dividends, and now you will withdraw your first amount of $150,000 to live on for the next year. Your portfolio has grown now from $3.94M to $4.14M after you have withdrawn your $150,000.
Fast forward 1 year to the end of 2023. Your money has been hard at work all year long, but this year you now have to account for inflation increasing at 2% – so your cost of living goes up. So, you withdraw $153,000 rather than $150,000, but this time your withdrawal is not 4%, rather 3.89%, and your overall balance has increased to $4.14M.
The 4% Rule works best if your withdrawals gradually decrease as a percentage of your portfolio over time. And that’s exactly what happens if inflation is kept at 2%, your stocks rise steadily at 7%, while paying you a stable 2% dividend yield. Sounds idea for your nest, right?
Here’s what this commitment would look like over the next 30 years. Everything is on an upward trend and increasing. Your cost of living is now $266,380, and your portfolio is at a whopping $25.2M!
Here’s a chart to depict how it will look over the course of 30 years. There’s a tiny sliver of red along the top that represents each year’s withdrawals. The green section is your portfolio.
So, all you need to do is follow the 4% rule. Accumulate 25X your annual living expenses and live off the passive income. Does this sound too good to be true?
By now, most of us know stock returns are anything but consistent.
The yield on dividends is anything from constant.
The rate of inflation is not stable.
It would be foolish to make a major decision based on assumptions that 7% returns, 2% dividends, and 2% inflation will remain constant for our entire retirement plan to be bulletproof.
Lucky for us, Aswath Damodaran, an NYU Professor of Finance has compiled an impressive amount of data and has made it available to us at Damodaran Online.
Historical Review With the 4% Rule
With this data, let’s take a look at the past and see how the 4% Rule applies.
1969, a fitting year to begin. Imagine Bob, he retired in the Summer of ’69 – a little over 50 years ago. Bob’s annual expenses were $21,000, the equivalent to ~$150,000 today.
Bob had planned out his retirement at a very young age and managed to save and invest his money. During that time, he accumulated $525,000, and put it to work in the stock market. Bob, being keen to his yearly expenses, desired to continue his same lifestyle standards and apply the 4% Rule. He knew that some years his portfolio would grow, and other years, it would decline, but he was determined to keep his investments in the S&P 500.
Keep in mind the 70’s were turbulent times in the economy with massive swings in the markets and inflation. The question is: “How did Bob fare during these times? Did his portfolio and lifestyle stand up to the test of time?”
As it turns out, Bob would have run out of money in 2010 using the 4% Rule. Granted it was 41 years later, you still don’t want to risk running out of money.
So, what happened?
Lessons Learned: The most important thing to remember is the early years of retirement are critical to the longevity of your portfolio. High inflation coupled with subpar portfolio performance in the early years might severely damage your portfolio and cause your savings to deplete sooner than expected.
For instance, Bob did not anticipate a significant stock market meltdown in 1973 and 1974 when he retired in 1969.
Because of the crisis and inflation, Bob’s withdrawals gradually increased to larger and larger portions of his portfolio until he eventually ran out of money – albeit 40+ years later.
The 3% Rule is Iron-Clad
Given the fact that the 4% Rule isn’t a guarantee that you won’t run out of money, what should you do?
There’s always the 3% Rule. It really matters on how conservative that you want to be. Back-testing Bob’s circumstances with the 3% Rule, he easily made it through and managed to build a significant amount of wealth. As a matter of fact, back testing the 3% Rule to 1800’s, there hasn’t been a scenario that would have failed. But that’s not to say the future has something else in store. See the chart below to see how Bob did with the 3% Rule.
So how can we decide which rule to follow? One approach would be, with a stress test of the worst economic conditions. We know that the early years of retirement are the most important for our portfolio. Another would be to take a conservative approach and save and invest large amounts, just-in-case.
Here’s a table of the worst years in history.
Using this data, we can construct a simulation to determine what the minimum amount of savings we would need, given the worst-case scenario presented in history. It’s not to say that it will work out perfectly but testing against the roughest years in history will give you a more reliable expected outcome.
Conclusion
Everyone should be prepared for their retirement. Whether you are single or a couple. Each individual person should prepare. The earlier that you begin planning and applying a solid strategic action plan, the better you’ll be prepared, and the wealthier you will be. It can be an intimidating task, but if you follow the 3% Rule, it can make things much easier. Start early and adjust your portfolio along the way is the ideal way to plan.
Although, I’m not a proponent of retiring early, I do think planning for retirement is imperative to any person or family and is a requirement to reach your desired financial freedom. Even if you have very little savings to begin, at least you know where to aim, without a target you have very little chance to be prepared for your future. The power of saving and investing your way towards your goal is the simplest and easiest way to get there.