What if I told you you could buy a perpetual money machine? Once purchased, you could continue to draw from it for the rest of your life, and it will never run out of money because it keeps making more. I can tell you how much it costs--there is a specific price tag. Are you interested?
The 4% Rule of Thumb
The 4% Rule of Thumb was the first idea that made me realize that a path to early retirement was actually achievable because it spoke to me in my language: math. As a skeptical and risk-averse person, I need proof, and the numbers gave me that proof. Let's look at what it says:
Original Idea for Regular Retirees (retiring at 65): You can safely withdraw 4% of your portfolio, plus 2% inflation each year, and expect it to last 30 years (at which time you're life expectancy is about up).
Early retirement adjustment: As long as you can earn above a 5.5% annual return on your investments, you can safely withdraw 4% of your portfolio plus 2% inflation each year and expect it to last 55 to 75 years. If you can earn 6.5% or better annually, it will essentially last forever because your returns will outweigh your withdrawals. (examples later)
How much does the Perpetual Money Machine cost?
Since the rule of thumb is 4% of your portfolio, your Perpetual Money Machine costs 25 times whatever your annual expenses are. So take whatever you spend in a year and multiply it by 25. Boom: that's the price tag on your money machine.
Your Perpetual Money Machine costs 25 times more than your yearly expenses.
Why 25? Because 4% times 25 is 100%. If you need to live on only 4% of what you have, then you need to have 25 times that amount. Putting numbers to it: if your expenses are $40,000, then in order for $40,000 to be 4% of your portfolio, your portfolio needs to be 25 times larger.
So $40,000 * 25 = $1,000,000.
Your money machine costs $1 million.
"Uh.. $1 million? That's Way More Money Than I Could Ever Save"
Not necessarily. Let's assume an 8% average yearly return on your investments (which is fairly reasonable).
If you decided to invest $1,000 per month, you can get from $0 in savings to $1 million in 26 years! If you started work right out of college at age 22, then you're retiring at 48!
Let's get committed and bump it to $2,000 per month. You now go from $0 to $1 million in 19 years! Again starting from 22, that's age 41!
Check out this chart:
What Are Your Expenses?
There are your obvious expenses such as housing, gas for your car, and food. But there are also less obvious expenses that you'll have to consider when calculating your number. Two of the big considerations are:
Healthcare: If your employer was originally paying for it, you'll have to account for the fact that it's up to you in retirement (at least until 65 when medicare kicks in).
Taxes: Don't forget taxes in your expenses. If you have your money in a tax-deferred account, then the money you take out will be income taxed. If you need $40,000, then you'll have to take out more than that to account for taxes, so taxes are part of your expenses. The same goes for capital gains in a taxable brokerage account.
On the flip side, any money that you can regularly earn during retirement can be subtracted from your expenses before multiplying by 25, giving a HUGE value on after-retirement earnings. This is because you won't need your portfolio to pay for that amount since you're providing it yourself.
For example, if you can find a way to stick around as an advisor at your company and only work 8-10 hours a week and get paid $20,000, then you just lowered your number by half a million: $20,000 times 25 is $500,000 that you no longer need to save because you're providing it yourself. If you can do some small earning on a hobby or anything else that provides $5,000 per year, then you cut your number by $125,000. ($5000 * 25 = $125,000)
Regardless if you're saving for a money machine or not, I suggest that you get a budgeting app such as Mint or Personal Capital to track your spending so that you know your expenses--knowledge is power.
Let's See an Example
Let's again use the example that you live on $40,000 each year. That means you'll need to withdraw $40,000 from your portfolio when you retire, so your portfolio needs to be 25 time larger.
$40,000 * 25 = $1,000,000
When you get to $1 million, you decide to retire. That year, you remove 4% of the portfolio: $40,000. (Hey, that's how much you need to live--it's almost like you planned it that way.) As you live, you expect your investments to be earning value to make up for the money you withdrew.
From that year forward, you will add 2% inflation to your withdrawal. Two percent of $40,000 is $800, so in year two you will withdraw $40,800. The next year, you will add 2% inflation to that. Two percent of $40,800 is $816, so you will withdraw $41,616. And so on.
Below is a spreadsheet I created that shows this idea at work. The first example is $1,000,000 growing at 5.5% annually, following the 4% rule. You can see that the portfolio lasts 53 years. At the bottom there are more examples with different starting balances and different rates of return. You can click through some of the examples to familiarize yourself with the concept.
The Risks
They say: "What sounds too good to be true, often is." As you saw above, this rule is based on math, so the concept itself is completely sound. Where the risks fall is in your investments. Will you earn what you need to stay afloat? Will you retire and then immediately be hit with a bear market? These are inherent risks in the strategy, and it helps to understand them. That's why we call it the 4% Rule of Thumb. It's mathematically sound, but nothing in life is ever as simple as it should be.
For a great, in-depth breakdown of the 4% rule as a drawdown strategy, I highly suggest reading the "Safe Withdrawal Rate Series" over at Early Retirement Now. It's a lot of reading, but it's also really important to understand this strategy if you want to use it. Remember, you can always start saving and investing now and then learn more about it as you go since you have the time while you're saving.
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