The answer depends on how long you want to retire for and how much you want to spend while doing so. Your overall ‘risk-appetite’ also plays a role. But first, let’s consider what we mean by ‘retired’.
The FIRE (Financially Independent, Retired Early) notion has become something of a movement among enthusiasts. The idea at the core of FIRE is to achieve financial freedom: to be able to enjoy life and spend all of your time without the constraints of a 9-5 job. For many, this is the nirvana of personal finance and it’s easy to see why.
In life, we all have three resources:
Each of these resourcescan effectively be traded for the other. We can sell our time at work for money. We can use money to pay for convenience saving us time. We can pay money to acquire skills and use those skills to acquire more money. While we are exchanging our resources, we are hoping to simultaneously take care of our needs and wants. Our needs and wants can otherwise be called our ‘Cost of Living’.
We live in a world where the concept of freedom is of the utmost importance. People go to war for it. In some sense however, we are not free until we are in the position that we no longer have to participate in the exchange illustrated above.
Financial freedom means we no longer have to trade our time for money, we are free to spend it. how we choose.
How much do I need to retire?
In order for financial freedom to be achieved, the goal is to reach a predefined number of savings which will then sustain (when using a ‘safe withdrawal rate’) an individual through retirement.
The question ‘how much do I need to retire’ relies on some key inputs:
- At what age do I want to retire?
- How much do I want to spend while retired?
The retirement age for most developed countries is about 65 but for many, the goal is not to accept this as fact, but strive to retire as early as possible. The average person can expect to live until around 80 years. As life expectations are consistently improving, it might even be reasonable to plan for 85.
Let’s say we’re slightly more ambitious than the average and we want to retire at 55. This means that we will need a portfolio of assets that can sustain our desired standard of living for 30 years.
Now we’ve estimated how long we will need the retirement fund for, we need to estimate how much we plan to spend each year we are in retirement. Let’s say that it costs 30k a year to live (which is close to the average annual cost of living for a single adult in the US) we’ll add 20k of discretionary spending on top of this to reflect that we’re enjoying our retirement, not just scraping by. The amount of living expenses has to be equivalent to or lower than our Safe Withdrawal Rate.
The safe withdrawal rate is the amount we can periodically withdraw from our investment without experiencing investment failure.
Investment failure is when we are no longer able to make periodic withdrawals, i.e. the fund has been exhausted earlier than we had planned.
In the previous example, we need our investment to provide us a total value of $1,500,000 (30*50k). If we wanted to just ‘scrape-by’ we would only need $900,000.
Does this mean that we need $1,500,000 in cash to retire at 55? Absolutely not. It would be highly unusual to hold a retirement investment entirely in cash. At retirement, most funds would be held in low-risk investments. Low-risk investments typically experience low volatility, however you would still expect some returns in the long run.
So what is the magic retirement number? Well basically, for a 30 year retirement, the answer is our annual spending, divided by 4%.
4% is our safe withdrawal rate for a 30 year retirement. But why? Where did this number come from?
In 1998 there was a retirement research paper known as the Trinity Study. The study considered a 50/50 split in assets held between the S&P 500 (an Index Fund which is designed and balanced so that it tracks the average return of the overall market) and government bonds. US Government bonds are considered among the lowest risk investments available, as such they have a low return which is sometimes referred to as the risk-free rate. This kind investment profile would be considered quite conservative which is consistent with the goal of a retirement fund.
The study examined data on the S&P500 and government bonds for the period from 1925 to 1995 and sought to determine what the maximum sustainable withdrawal rate would be at each retirement year.
The results show that a withdrawal rate of 4% would eliminate the risk of investment failure in every single year examined. This gives us some degree of comfort going forward that in a similar investment, our chances of experiencing investment failure over 30 years are very low.
If we apply the formula to our original example of $50,000 living expenses per annum using the 4% withdrawal rate (4%/ 50,000 or simply 50,000 X 25) we arrive at $1,250,000. The additional $250,000 reflects the return on investment that we would safely expect to earn during the life of the investment.
The Trinity Study authors later updated their study with data to 2009. They made the further discovery that at a withdrawal rate of 7%, the historical chance of investment failure is only 15%. This rate would bring our required nest egg down from $1,250,000 to only $715,000!
$715,000 to retire at $50,000 a year sounds extremely good. In this scenario we are expecting that most of our withdrawal income will come from investment returns, rather than the actual investment capital. This sounds too good to be true, however back-tested results show that this investment strategy has succeeded 85% of the time!|
So I can go higher than 4%?
If history is anything to go by the answer is probably. Have a look at the table success rates. The risk is a continuum based on withdrawal rates, the higher the rate the higher the risk of failure. Historically between 4% and 7% have been appropriate rates, with the latter being for those with a larger risk-appetite.
My personal opinion and strategy is to plan for a withdrawal rate of 6%, but it is absolutely a personal decision. I may well be wrong, however I’m using historical analysis which is unfortunately the only insight we have.
What does my original investment look like after 30 years?
You would expect a retirement fund to be depleted gradually throughout your retirement right? Wrong.
Let’s have a look:
A 30 year investment at a 7% withdrawal rate would grant a median return of 119%! Even after withdrawing 7% a year for 30 years our investment would actually make money.
If we stick with our safe withdrawal rate of 4% we still make a return of 710%. That’s the power of long-term compounding gains!
Problems with ‘magic numbers’ and how you should approach your retirement:
Target numbers are great in some respects, they give us a goal and something to work towards. They’re also great for ‘ball-parking’ the real cost of financial freedom however they are a few issues that need to be considered:
- History isn’t always an advocate for the future: the Trinity study was performed on historical data. While this data can give us some indicator of future events, we simply don’t know how things will unfold. The perfect scenario is to retire right on the cusp of a market boom, however these things can’t be predicted reliably. Retiring just before events like the Great Depression or the Global Financial Crisis is a possibility. These events can rarely be planned for but can destroy retirement funds. This doesn’t mean we should ignore history, just rather accept that anything truly can happen.
- The calculation doesn’t include inflation: Inflation directly eats away at our investment returns. It doesn’t matter if our investment value increased by 3% if the cost of everything also increased by 3%. Any calculation should be adjusted for inflation, noting that this is something else that will need to be forecasted and deducted from our withdrawal rate.
- The calculation doesn’t reflect how an actual investment would be managed: An actual investment would likely be managed over its life. Investments should be consistently reevaluated. During boom times the investment mix might be able to take advantage of some run-up in stocks, while in tougher times the asset mix might move to an even more defensive strategy. Further, in reality with the withdrawal rate is not ‘fixed’. Depending on the performance of the investment, the withdrawal rate can be adjusted. For example, if the investment has been under performing for the first decade, a lower withdrawal rate can be adopted. The reverse is also true.
- Passive Income: the calculation doesn’t include any passive income considerations. Passive income can provide an on-going revenue stream into retirement. Be careful when factoring this in as 30 years is a long time to guarantee a passive income stream.
Calculate it yourself:
Here’s a calculator I coded myself which incorporates the data compiled in the Trinity Study. You can compare and contrast different retirement lengths, living expenses and withdrawal rates and see the impact this has on your required investment portfolio. You can also see what your portfolio’s success rate looks like and what it would look like at the end of your retirement- all based on over 80+ years of actual market returns.
In order to find your ‘magic retirement’ number, take your planned annual living expense and divide it by your ‘withdrawal rate’. History has shown that a rate between 4% and 7% will result in a very low chance of investment failure. Don’t forget to consider that ‘magic numbers’ are simply guides. While they are based on research, history is not always a road-map for the future.