How much money do you need to retire: The 4% rule
It’s a widespread belief that retirement is possible between the ages of 60 and 65.
That is because you’ll have to rely on a retirement pension to cover your expenses for the rest of your life. What if you didn’t have to?
Wouldn’t it be extraordinary to accumulate enough money to retire 10 years earlier? How about 20 years? Dare I say 30 years earlier?
That is called financial independence.
The 4% rule tells you exactly what amount of wealth you need to reach financial independence.
After laying out some personal financial principles necessary to fully understand it, I’ll explain the 4% rule and help you quickly calculate precisely how much money you need to reach financial independence.
Active vs. Passive income, ROI, and Inflation
Every person with a sound financial plan has a thing in common: They use passive income to build wealth.
Taking advantage of passive income is infinitely more productive than relying on active income. That is because you don’t have to trade your time for it. It allows you to reverse the equation: to make your money work for you.
Once you have enough money working on its own to produce your income, you won’t need to work one more day your whole life.
Now, there are better means of passive income than others. The way to compare them is through ROI (return on investment). Let’s use an example to simplify comprehension:
Exactly one year ago, I purchased stock worth $100. Now, this stock is worth $110. Let’s assume there is no transaction fee.
ROI = Net income / Cost of investment = $10 / $100 = 10%
If I choose to sell the stock, my return on investment would be 10%. That means I put $100 to work for me for a year and returned an interest of $10.
The higher ROI, the better. Figuratively, that means your money is working harder for you.
To reach financial independence, the goal is to have enough invested that you can cover all of your expenses with your interests only.
That way, you’re still on a budget but don’t have to work to win money anymore.
Let’s use another example:
Our friend Jack respects a budget of $30,000 per year. He invests part of his active income in producing passive income. After a while, his investments give him an interest of $30,000 in a single year.
He just reached financial independence, meaning he no longer depends on active income.
Notice here that all of his money invested stays invested. He only spends his interests.
Now, you probably tell yourself: It sounds too good to be accurate. For sure, it’s not that simple.
You’re right!
There are two more concerns to address to ensure Jack has indeed reached retirement.
He has to be sure his investment will produce at least the same ROI every subsequent year. Otherwise, he’ll receive less money at some point than he spends.
That will force him to either go back to work or spend the money he has invested, reducing the interest he’ll gain next year.
Inflation isn’t taken into account.
Inflation is the reason grandpa can no longer buy a soft drink for $0.10. With time, the cost of every product and service increases.
That means Jack’s budget of $30,000 this year won’t be enough to cover his expenses next year.
To address those concerns, the 4% rule comes into play.
The 4% rule
The famous 4% rule was born from an economic study done in the 1990s by a financial analyst called William Bengen (1). It has been since tested many times to ensure it still holds value.
It is based on the performance of stock markets. The inventor of the rule relied on the history of market returns and came to the following conclusion:
During the first year of your retirement, add up all your investments, then withdraw 4% of this amount.
In subsequent years, withdraw this same starting amount adjusted to follow inflation.
Over a 30-year retirement period, it’s safe to assume that your initial investment will never run out of funds.
In other words, you must save money until 4% of that amount equals your total expenses for one year. Then, you will be able to rely solely on the interests gained for the next 30 years. To achieve this, you’ll have to keep the same lifestyle.
If you plan on living more than 30 years after that point, the 4% should be adjusted to a more conservative number. This rule should not be followed blindly, simply because past behavior of the financial markets doesn’t guarantee its future outcome. It still provides a good ballpark amount.
That said, assuming this assumption is valid, it is possible to know the amount necessary to invest in the stock market to allow you to achieve financial independence.
How much money do you need to retire?
The financial wealth allowing you to retire is easy to calculate. You only need to know one variable: The amount of money you spend in a year.
Since this number equals 4% of the total wealth you need, we can use a simple calculation.
Wealth needed to retire = One year’s expenses / 4%
e.g., Jack’s financial independence = $30,000 / 4% = $750,000
Here’s a table comparing different monthly budgets with their corresponding amount to reach financial independence.
Note here that the bottom line amounts are in millions of dollars. For example, someone who respects a budget of $2,000 per month must have invested $600,000 in the stock market to consider themselves financially independent.
You can see the direct impact of your consumption habits on your future ability to retire without relying on pension funds.
Increasing spending is a double-edged sword. Not only is it more challenging to save, but the amount you need to support your lifestyle also increases.
Conclusion
You are now equipped to find out what is your magic number to reach retirement. The best thing about the 4% rule is that you only need to know how much you spend.
Two crucial practices are highlighted here to ensure your future personal wealth. Those are budgeting and using passive income with the most significant return on investment possible.
Getting good at controlling these could be the best investment you will ever make. Imagine all the time you would have to accomplish your dreams if you didn’t have to exchange it for money.