Dear Rich Lifer,
You’re probably familiar with the ‘4 percent rule’ and ‘Multiply by 25’ rule.
If you haven’t heard of these rules, don’t worry! I’ll explain in second.
But first, I’m willing to bet that those of you who have heard of these rules are getting them confused.
Multiply by 25
The ‘Multiply by 25’ rule estimates how much money you need to retire worry free.
Here’s how it works: multiply your annual expenses by 25.
That’s it. Simple right?
For example: if you estimate your annual expenses in retirement will be $40,000, you will need $1 million saved in your retirement portfolio ($40,000 x 25 = $1mm).
If your lifestyle is a bit more extravagant and you spend $70,000 per year, you’ll need $1.75 million ($70,000 x 25 = $1.75mm).
Notice that this rule doesn’t take into account any other sources of retirement income, like Social Security, pensions, rental properties, etc.?
This is because the rule was created for early retirees, who likely won’t have access to Social Security or pension income until later.
Since you will likely have some form of guaranteed income if you’re already close to retirement age, you can easily adjust your annual expenses accordingly.
For example: if you expect to receive $20,000 from Social Security, your nest egg will only need to cover $50,000 in expenses (instead of $70,000). Your retirement goal would then be adjusted to $1.25 million ($50,000 x 25 = $1.25mm).
The ‘Multiply by 25’ rule also assumes your portfolio will generate a 4 percent return per year. It’s estimating that stocks will produce an average return of 7 percent per year.
If that 7% figure is accurate, and we assume inflation keeps pace at roughly 3 percent per year, then your return — after inflation — will be about 4 percent.
Then What is the 4 Percent Rule?
Where most people get confused is assuming the 4 percent rule is referring to the 4 percent return, like we just calculated.
But, the 4 percent rule is only telling you how much money you can safely withdraw once you’re retired, without dipping into your original investment principal.
Here’s how it works: the 4 percent rule states that you should withdraw 4 percent of your retirement portfolio in the first year, and continue withdrawing the same amount, adjusted for inflation, each year after that.
For example, if you retire with $1 million, then in your first year of retirement, you should withdraw $40,000 ($1mm x 0.04 = $40,000). The following year you withdraw the same amount, adjusted for inflation. If we assume 3 percent inflation, you withdraw $41,200 ($40,000 x 0.03 = $41,200).
Depending on how the stock market performed that year, your $41,200 might be worth more than 4 percent of your remaining portfolio or less. The good news is this rule of thumb has been tested over decades. William Bengen, who pioneered the 4 percent rule, tested 30-year spending rates against the historical returns of US stock and Treasury bonds.
Some years the markets went up and some years they went down, but the 4 percent rule takes this into account. As long as you withdraw a steady amount, plus inflation, you shouldn’t run out of money.
Bengen says this rule would have protected your annual income even during 30-year periods that included the Great Depression of the 1930s and Great Stagflation of the 1970s.
What Exactly is the Difference?
The ‘Multiply by 25’ rule estimates how much money you need to save to retire. The 4 percent rule estimates how much you can safely withdraw from that portfolio.
“I’ve heard the 4 percent rule is risky”
Some financial experts will tell you the 4 percent rule is too aggressive. And that you should be withdrawing 3 percent. They also believe that the ‘Multiply by 25’ rule should really be ‘Multiply by 33’.
There are three caveats to the 4 percent rule:
- It’s not guaranteed. Yes, it’s been tested multiple times and it works almost every time. But, a bad market in the first few years of retirement could make for trouble.
- Asset allocation matters. William Bergen says your allocation to stocks should be no less than 50 percent and closer to 75 percent.
- Don’t forget investment fees. If you invest with an advisor and you’re paying even one percent a year in fees, this can affect the 4 percent rule.
If you’re really worried about running out of money in retirement, then following the 3 percent rule and ‘Multiply by 33’ rule will give you a more conservative estimate. But, which one you choose to follow also depends on your unique situation, risk tolerance, and taxes — all of which I’ll save for another day.
To a richer life,
Source: Daily Reckoning
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