By this point, I’ve been yammering on about our net worth and expenses for about 9 months, exposing our financial secrets each month in excruciating detail. And at some point in each financial update post, I typically comment on how we’re x% of our goal to financial independence. Which is great and all, but what does that really mean, other than fueling my obsession with spreadsheets? If our goal is to hit this magic FI number and then be able to quit work and travel the world at our leisure, how do we know when we have enough to last us the next 60+ years of our lives? If that sort of freedom sounds enticing to you, you’re probably then wondering, “How do I calculate my FI number?”
The 4% Rule
Not surprisingly, that question has been raised by prospective retirees for decades. The fear of giving up the relative stability of a regular income is (rightfully) one of the biggest fears people face going into retirement. Nobody wants to run out of money, especially in their senior years when they may not be capable of returning to the workforce. But with the phasing out of corporate pensions over the last few decades, this issue has become paramount to retirees’ success or failure since they no longer have the security blanket of guaranteed income to fall back on.
In the early 1990s, a financial advisor by the name of William Bengen had received the question of “how much do I need?” from his clients enough times that he started to gather some data on his own. Essentially, he sought a universal Safe Withdrawal Rate that would answer that question in nearly certain terms. So he took data going back to the dawn of the US stock market in 1926 and crunched some numbers. He adjusted for inflation and crunched more numbers. Bengen tested different ratios of equities and fixed income and crunched more numbers (sounds like my kind of guy).
What Bengen concluded in 1994 was that a retiree with a 30-year retirement time horizon could withdraw up to 4% of their retirement portfolio, adjust that amount each year for inflation, and they would have been successful in not running out of money in every historical scenario tested. The 4% Rule was born!
The 4% Rule was later tested in 1998 by a group of professors at Trinity University in Texas, who concluded that a 100% stock portfolio with a withdrawal rate of 4% had something like a 95% chance of succeeding over a 30-year time horizon when tested under all inflation-adjusted historical market conditions. Sounds pretty solid, right?
Caveats
- The first issue that should stand out from the previous paragraph is the phrase historical market conditions. How many times have you seen investment advisor commercials that paint this rosy picture of retiring to a pair of steaming bathtubs overlooking a picturesque valley, glossing over the narrator’s statement of “past results are not indicative of future performance”? How can we trust our financial future to a rule that is entirely based on the past?
- Not only that, but the study was based on surviving a 30-year retirement horizon. Given that I’m only 31, I’m obviously hoping my retirement far exceeds 30 years. How do you project out to 50 or 60 years? Does the 4% Rule still hold up?
- Lastly, Bengen and the professors from Trinity did their work on data through the early 1990s. Their studies are almost as old as I am at this point…does the data still support their assertions?
Rebuttals to the Caveats
- Alright, I totally agree that how the stock market performed in the past can’t guarantee how it will perform in the future. But these studies tested all historical scenarios…even the very worst. Like starting your retirement in 1929 at the advent of the Great Depression. Unless we see a market swing worse than the Great Depression immediately after retiring, I think we’re going to be okay on this point. There are no promises, but I’ll play the odds on this one.
- I’ll also admit that I don’t know how the 4% Rule stacks up to a 60 year retirement horizon. But the trusty Spreadsheets have projected that all out for me, so I feel pretty good here too. It’s important to note that the 4% Rule is more of a Rule of Thumb…meaning it should still be customized to your individual situation. In my Spreadsheets, I’ve done a pretty conservative modeling of returns, choosing 6% annually when data suggests the stock market has historically returned an average of 8-10%. Aside from that, we’ve modeled out a dynamic spending plan that allows us some flexibility. When the market is doing well, we should be able to take that extra vacation we’ve been planning. When the market contracts, we know exactly where we can cut expenses and do our best to maintain our investment principal. No different than during our working years.
- Of course, we’ve seen some challenging times for the stock market since the early 90s. We don’t yet have data on how our retirement horizon (or even a 30-year horizon) would play out if it started during the Great Recession of 2007-2009. To that argument, I fall back on Bengen’s initial work – he tested all scenarios. I’ll bet on our future investments at least outperforming the very worst they have ever performed in history. If they don’t, we’ll all be in a world of financial hurt. Additionally, several individuals have repeated the experiment more recently with similar results.
How the 4% Rule translates to your FI number
That’s a long-winded way of setting up the real reason for this post: how to calculate your FI number. If we take the 4% Rule as something close to gospel, it really just becomes simple algebra:
Annual Expenses = 4% x Retirement Portfolio
We’ve done a pretty substantial amount of planning to determine what we want our baseline Annual Expenses to be in retirement. Given our 2021 budget of $57,000 and the relatively high cost of owning our home included in that amount, we’re pretty confident we can cut our Annual Expenses down to $50,000.
*The most important part of this equation is your expenses! Many financial planners use your current income as the baseline for how much you are going to need to replace in retirement. What good does that do? We already discussed how your income in retirement isn’t likely to be guaranteed, so current income is irrelevant in my opinion. So many Americans already attempt to live off of more than their current income, ending up in substantial consumer debt. If they paid attention to their expenses, they would likely be in a different situation. But I digress…
Back to the math:
$50,000 = 4% x Retirement Portfolio
Simplifying…
$50,000 = 0.04 x Retirement Portfolio
$50,000 x 25 = Retirement Portfolio
$1,250,000 = Retirement Portfolio
There it is! The way to calculate your FI number is to take your anticipated annual expenses and multiply by 25. (To belabor the point, you’ll notice there’s no mention of your current income level in that formula).
So as it stands, our FI number is $1,250,000. Ending last month just over $1,000,000 in net worth leaves us over 80% of our goal to financial independence.
Conclusion
The first, most obvious conclusion here is that the 4% Rule is more of a guideline than an actual rule. Everybody will have have unique needs and goals for their retirement and should customize their plan accordingly. I bashed financial advisors a bit in this post, but I do believe it’s probably a good idea to consult a professional at some point during your retirement planning to respond to your particular situation.
In a world desiring immediate answers, the 4% Rule will do just fine as a baseline for calculating your FI number. For us personally, it’s just a starting point for the Spreadsheets to work their magic. I’ve projected our annual income and expenses until the age of 100, using conservative market returns and increasing expenses later on in life for anticipated rising health care costs. It’s unlikely that we will hit exactly $1,250,000 and immediately decide to quit our jobs that day, but having that number in the back of our heads after a bad day at work certainly helps.
Now that I’ve shown how to calculate your FI number, how close are you?
