The golden rule of retirement – don’t outlive your money. So, how much do I need to retire and not worry about running out of money?
The problem is how can you be sure you won’t outlive your money. The general rule of thumb has been you can comfortably spend 4% of your retirements assets every year and not risk spending down your principle.
How realistic is the 4% rule?
With the 10-year Treasury selling at less than 2%, is it realistic that you can consistently generate 4% on your assets. I have had an aggressive growth portfolio that’s been generating 6% for the past few years. Keep in mind that this is 6% growth with a standard deviation of 12% meaning I should expect a return of anywhere between -6% and 18% every year.
So if 4% is too aggressive, what is reasonable? A more conservative approach would be to tie your return expectations to the 10-year Treasury. The problem with this thinking is that even at a 2% yield, you will need $10 million in assets to generate $200,000 per year in retirement income.
Considering the average American has less than $200,000 in investment assets at retirement, does getting that number up to $10 million just seem ridiculous?
So what can we do?
The stability of your retirement will be dependent on two things – how much you are spending each year and how much passive income you can generate. This assumes you don’t want to continue actively earning income in your retirement years.
So if those are the factors that impact your retirement, let’s start working on both of those things today.
Create sources of passive income and reduce your living expenses.
Two questions – What are your annual expenditures? How much do you earn in passive income per year?
This is your starting point.
You will know that you can retire comfortably when those numbers match. And the added benefit is that if you do it well, you won’t need to touch your principal so you’ll have a nice inheritance to leave for someone. And you won’t need to worry much about the return your portfolio is generating.
Meet Jake and Dan
Let’s look at two hypothetical scenarios:
Both Jake and Dan begin working at age 22 with a starting salary of $35,000 per year.
Jake saves 20% of his gross salary every year and invests the savings into a retirement account earning 4% after tax. Each year going forward, Jake receives a 2% cost of living raise and continues saving and investing 20% of his salary.
By age 65, when Jake decides to retire, his salary has increased to a modest $80,000 per year, he is spending around $50,000 per year, and he has $1.2 million saved.
Jake’s $50,000 in annual living expenses will continue to increase 2% per year due to inflation, so assuming a 4% withdrawal rate, Jake can safely withdraw enough money from his account to pay his living expenses even if he lives into his mid 90’s.
Now let’s look at Dan.
Dan started out at the same salary as Jake, but received 10% annual increases such that by the time Dan was 45 years old, he was earning over $300,000 per year. Unfortunately, Dan wasn’t as frugal as Jake. By the time he was 45, his expenses exceeded $200,000 per year and he had only been able to save about $200,000.
It was at this time that Dan decided he needed to start saving; unfortunately, he struggled with where to find it. He had a big mortgage, multiple car payments, a boat, school expenses, country club membership, annual vacations, and large monthly dining and shopping bills.
The other problem Dan faced was his pay increases had started leveling off. Instead of 10% increases, he was now only receiving 3% annual increases.
But over the next few years, Dan was able to reduce his expenses by about 5% per year, such that his spending was down to around $150,000 per year. Unfortunately, it was at this time that Dan was laid off and unable to find another job for a year. It’s not uncommon for lay offs to hit the higher income earners more than the middle or lower income earners. When a company is having financial problems, they can make a bigger impact by cutting big wages. When Dan did eventually find a new job, it paid significantly less than he was making previously. And because he had already cut his expenses, there wasn’t much more to cut without changing his lifestyle. So Dan started dipping into his savings to pay the bills.
As Dan approached retirement age, his salary had rebounded, but because he hadn’t cut his expenses, he only had about two years of living expenses saved. This is hardly enough to serve as an emergency fund let alone support retirement.
As such, Dan continues to work well into his 60’s, earning a nice big salary, but without any of the freedom that Jake now enjoys.
It’s About the Spending
The obvious take-away from Jake and Dan is to start saving early. For most of us, our expenses are low when we’re young. Once you start spending, it’s hard to cut back.
The other take-away is that having enough money in retirement is less about generating a return (4% vs 2% vs something else) and more about how much you are spending.
To me, it comes down to priorities. If you like your job enough to want to continue working well into retirement, that’s great. Maybe there’s something else you can do during retirement to bring in additional income. I know a retired former CFO who now does taxes for individuals and small businesses. The majority of the work happens in the first quarter of the year, and the rest of the time, he’s retired.
But the more you can keep your expenses low, the greater flexibility you will have and the better you can answer the question, how much do I need to retire?
Readers, have you asked how much do I need to retire comfortably? How close are you to meeting that goal?
I’m striving to be a multi millionaire by the time I retire. I think I should be able to reach a $1M net worth in the next few years and hope I can continue to grow my income at its recent pace. We just don’t know what can happen tomorrow so we must make the most of each day today and hustle to grow wealth while we’re still physically and mentally able.View Comment
Financial Slacker says
Because I have always focused more on growing income rather than minimizing expenses, I often think about “what might happen tomorrow.”
When you have a large expense hurdle, it’s hard to imagine building a passive income stream substantial enough to cover. So you tend to worry about maintaining the active income stream – the succes trap.
Sounds like you have already mastered the expense side and are focused on building the capital side.
Thanks for sharing.View Comment
I’m not sure as to how much we’ll need to retire and when but we’re currently focused on getting rid of as much debt as soon as possible as well as saving as much as we can.View Comment
Financial Slacker says
I have adopted the rule of thumb that you need 25x your annual retirement spending in order to retire and not risk running out of money. If you’re under 40, I would target 30x annual retirement spending.View Comment
Our plan is based on the 4pct rule. As input, I takee our current spending. It isthe best guesstiate I can make for now. I have a planning spreadsheet where I can enter some life events and variations in spending.
Today, we are about 25pct down the road!View Comment
Financial Slacker says
I have used 4% as well, although more recently, I have started to think I might feel more comfortable bumping up to 30x spending. Or even better, I am moving my assets toward income generation so I know exactly how much cash flow I have.
Sounds like you’re in pretty good shape. And from my experience, the first 25% is harder than the rest. Once the benefits of compounding start kicking in, the numbers add up much more quickly.View Comment
It is also our plan to have a big part in cash flow generating assets by the time we retire… The peace of mind it gives is priceless.View Comment