For the record, I’ve only once asked a girl for her number. It was October 2007 and I was out in Fells Point in Baltimore. Also, for the record, I got the number. However, when I finally texted it a couple weeks later to go out for Halloween, I got no response. Yes, I will acknowledge that it may have been a fake number. Her loss, I suppose, as I’m certain whomever she ended up with could not compare to this (thumbs pointed in).
In 2000, the Clay Mathematics Institute published the seven millennium problems. Problems thought to be so difficult that solving any of the seven garners a $1,000,000 award. The first of the seven problems was solved in 2010. Today, I hope to solve the second: How Do You Find Your Retirement Number?
For Retirement Planning, there are four very simple equations to determine how much a person needs to retire. The ultimate “nestegg” question.
The Two Questions You Need To Ask
To determine which of the four equations applies to you, you need to ask yourself two very important questions:
- Do you, or do you not, want to decrease your asset base during retirement (working toward zero)?
- Will you, or will you not, have any current income (pensions, side work, royalties, rental cash flow, passive income generated outside of your investments)?
Let’s discuss those two questions a bit more in depth.
Question 1: Drawing Down Assets
We’re all familiar with the 4% safe-withdrawal rule. This oft-cited retirement mantra comes from the Trinity Study: if a person withdraws 4% of their nestegg (blended as 75% stocks, 25% bonds) in Year 1 of retirement, and increases that withdrawal by the growth in CPI, then that person would have a very high likelihood of not outliving their assets over a 30-year retirement. Using FireCalc, we can see this to be true:
Starting with a $25 portfolio (75% stocks, 25% bonds) and with $1 (real dollars) yearly withdrawals, only in the most extreme cases would an investor ever hit a zero balance, and that would only come after the 25th year.
This 95% success rate is a high enough to give most retirement planners a firm footing. Draw down 4% each year and call it a day.
The problem though, is when you start talking about 60 or 70 year retirements. If I retire as planned (at age 34), then I could reasonably live another 50 years, and could possibly live another 65 years. So, how does the “4% rule” stand up for these ultra-lengthy retirements?
As you can see, over a 65-year horizon, the frequency that lines fall below $0 increases quite a bit, evidence by a much lower 81% success rate. Not nearly as good, as this essentially means that if you are going to be retiring in your 30s with 25x your yearly expenses saved up, then you’ll run out of money in one out of every five 65-year retirements. Granted, this doesn’t account for any social security, so you’ll probably be fine. But, lest we forget, it was Custer that said the Lakota probably sleep in late during the summer.
More than these pretty pictures, though, is the psychology behind asset drawdown. I simply would go nuts selling shares to fund my lifestyle. Not only does selling shares decrease your productive assets, but you could also have to sell shares at inopportune times. As I argue here, structured and periodic asset drawdowns is the exact opposite of dollar-cost averaging. In drawing down a fixed asset amount, you are selling more shares when prices are low, and selling fewer shares when prices are high. For this largely psychological reason, I would be very uneasy drawing down my assets in retirement. So, to answer question one, “I Will Not Draw Down My Assets.” Rather, I will only use the yield (interest and dividends) that pay out to me. In a sense, I’ll drink the milk, and leave the cow alone.
Question 2: Current Income
For most of us, retirement does not necessarily mean “no more income.” Many (two-thirds, in fact) will choose to hold part-time jobs, “side hustle” or have some type of regular income coming in from “work-lite” activities. Many want to keep working a little bit to stay sharp, maintain social interaction, continue to feel value, or continue to create—all on their own terms, of course. “Income” could also include things like pensions, social security, royalties, AdSense income from a struggling financial independence blog, freelance or consulting work, or what-have-you. In fact, I’m hard-pressed to even envision a scenario where somebody makes zero income outside of only your investment income. You’d have to be an illegal immigrant (No SSN) with no desire to create, no pension, and no desire to ever do another act or service for compensation. I’ll continue writing throughout retirement. Maybe Retire29 will make a bit of money. Also, as I continue forth on my CPA, I would love (read: truly enjoy) to do personal tax consulting and/or preparation during tax season—if for no other reasons than I’m a nosy person who likes getting in people’s business as well as a penchant for screwing one over (legally) on ol’ Uncle Sam. I’m sure I’ll charge a little for this service. The answer to question two, is then: “I will have some current income.”
Note 1: “Income” cannot include income generated from your nestegg. Like interest or dividends.
Note 2: For these purposes, rental property should be viewed as an income source, rather than an investable asset or part of your nestegg. Take your monthly cash flow from your rentals as current income.
The Four Equations
Alright, lotta math goin on there, but it’s really not bad. Em is your monthly retirement expenses. Im is your monthly retirement income. And “yield” is the aggregate yield of your investment portfolio (probably something like the weighted dividend yield).
The top right cell, highlighted, is the way I’m gonna go. If my retirement expenses (which I’ll detail in the next post) are $2,000/mo and I’m actively making $6,000/yr ($500/mo) from writing, part-time wages, Retire29, or whatever else, then I’ll need my portfolio to generate $1,500/mo. If you look at my portfolio, right now it is yielding 3.5% or so. Plugging those into the top-right equation means that I’d need $514,285 of productive, investable assets to retire.
Working the other way around (which might look easier), if I have $514,285 in a portfolio that yields 3.5%, that will give me $18,000/year in income, or $1,500/mo. Add to that the $500 I make on the side, and that covers my $2,000 of monthly expenses.
Also important to note is the disposition of this $514,285 across taxable (ready to go) investments and tax-deferred (IRA, 401ks, etc.) investments. As I explain in length here, only one-fifth of your nestegg needs to be in taxable investments. The rest can be in tax-deferred investments, as those tax-deferred investments can be converted to taxable without taxes or penalties regardless of age.
Why Is This Any Better Than The Rule of Thumb?
I know what you’re thinking. “Eric, this is simply too complicated.” Why can’t I just go with what Mr. Money Mustache says, and just save up 25x my yearly expenses.
Dear Reader:
I would not argue against that path at all. After all, the highway you choose is far more important than the exit you take. However, the 25x rule of thumb has two major flaws, IMO. One, it is not perfectly suited for very-long-term retirements or personalities that are very loss-averse (like mine) and that will get nervous when selling shares. Two, it entirely omits the real and often very important impact that a little bit of income can have in retirement. If my portfolio is in the S&P 500, yielding 2%, for every $1 I earn during a month of retirement, my portfolio needs to be $600 less. Likewise, I also wanted to reiterate the power that expense reduction can have on early retirement. If you know someone that was scammed, you can help them by sending Funds Recovery reviews.
For those looking to retire very early, saving a big pile of money is obviously of the utmost importance. However, also very important is the ability to lower expenses to the extent possible without sacrificing happiness. And equally important is the ability to generate cash flow from outside sources, as that greatly decreases the dependence you’ll have on that fore-mentioned big pile of money.
In my next post, we’ll run the numbers on Retire29, putting real expectations of what my retirement nestegg needs to be based on my expense and income projections.
What do you think? Is this all just lunacy?
Thank you for reading, my friend.
Eric
Eric,
I am right there with you in attempting to live of the income/dividends from my investments, instead of dipping into the principal. To take that thought a step further; I want to be able to live completely off only one income stream, with a couple back up plans that could also support us just in case. That appeals to my frugal and fearful nature of things that I can bump into in the dark!
There are many bloggers in the community that think $700k to $800k saved would be enough. For those in their 30’s, that needs to be enough for decades to live off their nest egg. This might require years of extreme frugality after they retire. It could be a difficult adventure…
Take care,
Bryan
Hey Bryan,
You’re right about the extreme frugality, which is why paying off our home is essential to the plan. No mortgage/rent payments is a huge step toward limiting expenses.
Eric
Retire29 recently posted…My Emergency Fund Looks A Lot Like A Roth IRA and a Credit Card
I like the approach… I greatly shifted my focus from asset building to income producing about a year ago… I had a vision of $1.2M net worth and all would be good in the world… I know I’ll make some other money along the way, but who knows what that will be.. I have shifted my focus to earning $40K a year in passive income as way to have steady income and I can manage buying and selling assets as necessary in the future.
Currently I earn about $8K a year in passive so a ways to go, but I’ve come along way since prior to last year it was around $1K a year..
The hard one to wrap my head around is costs during aging.. medical mostly.. I plan to have housing taken care of so it will only taxes going forward from when I retire. Look forward to your running the numbers.
$40k seems like a good goal, and is probably not too far off from where we will hit retirement. It might be a bit excessive for us if we are without a mortgage, where I’m thinking 30k will suffice and 35k will be more than enough.
$8k can turn to $40k in a hurry, though, through reinvestment, new capital, dividend increases, and higher rates. Next years’ forward passive income is going to jump by about 30% for me–if I can just do 20-25% for a few more years, I’ll be sittin pretty.
Eric
I love math, but for retirement I’ve decided to rely on a the 25x rule as a rule of thumb. I still have a pretty complex spreadsheet, but I prefer the simpler rule because the markets are so volatile that even the most precise mathematical plans can blow up overnight. I guess the dividend portfolio gives you a more predictable yield, though, so I can see why you’re looking at it this way.
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Of course, nothing wrong with defaulting to the old 25x rule. The mindset is certainly what’s important. Whether you take passive income or safe withdrawals, the end state will be quite similar.
Eric
Retire29 recently posted…My Emergency Fund Looks A Lot Like A Roth IRA and a Credit Card
I think it is a pretty conservative way to do it. The SWF of 4% also includes a yearly adjustment for inflation.
For us, we just try not to adjust our income each year for inflation, just keep pulling out the same amount until it just won’t cover the expenses any longer.
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Hi Steve,
That’s certainly an interesting approach (not adjusting the withdrawal for inflation). I think that’s a very good plan and probably makes 4% SWF sustainable even for very long periods.
Eric
Hey eric,
a good practical overview on how to deal in different situations with the FIRE question.
It makes sense to me, as a starting point. It will help to define the goal you need to reach. while on the journey, some variables will change so adjustments are needed. I guess it is a good practice to evaluate each year where you need to be.
Question I have is: what buffer do you apply to the SWR (do you take 300 or do you add some buffer and go up to 333?) and the yield.
My medium goal is with income, maintain assets.
Right now, I am in accumulation, most of it is in indexes and funds that do not pay a dividend.
I am slowly building up my dividend tree (very humble, forward looking yearly now is 115 EUR – i have to start somewhere)
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Hi AmberTree,
No specific “buffer” amount, however, I think if I can have a 20% buffer, that would give me some confidence that I could weather some big dividend cuts or lifestyle changes. 20% is arbitrary, though.
You gotta start somewhere, as you said, on that dividend income. Best part though, is how quickly it can grow once you get going.
Eric
Nice discussion Eric. No, I definitely don’t think the 4% rule of thumb was intended for early retirees. Having a variety of income sources and living below your means is the only way to provide a margin of safety in early retirement. Of course if the economy enters a depression, I always figure I can do some part time work to increase our cash flow.
Hope you have a great week!
-Bryan
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Hey Bryan,
Yeah, mixing it up with some current income definitely provides some flexibility in the retirement equations. The 4% rule is still a great rule of thumb, but increasing the conservative hurdle by only living off passive income will allow me to sleep more soundly.
Eric
Good read. I also plan to have some additional income, but have not gone into such great detail as I think the 4% rule gives some cushion. Also, if the market were to really tank early on in my retirement, I could still have high earnings potential at that point to help rebuild my portfolio.
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Life is nothing but a series of unknowns. What is lost upon those who decry early retirement is the general ease for retirees to adjust to economic and market conditions. It’s not an ideal scenario, but if things really hit the fan, I can just go work a little bit.
Eric
When using CfireSim you can simulate part time work for the years you think you will get some $$ (because you probably won’t after a certain age). Your retirement date is the date you switch to part time work, and then you add the part time $$ earned in Income (from XX to XX ) . I think this is better than assuming part time income until you die.
I think your approach is ultra conservative, to only withdraw the yield of your portfolio. It adds many many years of accumulation (vs the 4% method) for not that many percentage point more security. You will always be ahead of 95% of the population because you saved much more. If your 4% method fails, it means the economy will be in a very shitty state, most people will have zero money and savings, and you will start worrying about other priorities than your withdrawal rates…
Hi Guillaume,
Thanks for the info on the ability to add current income. You’re right that I should assume current income until death. However, I’m really only concerned with the first few years of retirement. My belief is that money will really not be a concern for me after a decade or so, as my income will continue to rise as dividends rise, and I’ll likely be eligible for some social security down the line.
Add to that the likelihood that expenses will fall as I age (or at least trail inflation), and I should be quite financially sound over the long term.
Eric
As a numbers guy, love the equations. Of the suggestions you make, for me the top technique for maintaining peace of mind is to keep earning some kind of income, no matter how small. Side hustles, blogs, part-time work–just a little incoming cash flow helps a lot, psychologically if nothing else. I’d have to save up a huge nest egg to resolve at, say, age 34 to never more income. Plus, isn’t one objective in retirement to stay sharp, motivated, satisfied, and interested in life? I think pursuing interests and passions in retirement can advance these goals. Do what you want, spend as much time doing it as you want, have fun doing it, and with a little imagination and diligence there’s probably a way to make some money doing it too!
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Kurt,
Thanks for the thoughtful comment, and I fully agree. Having some income not only directly offsets expenses (leaving your nestegg to grow), but also increases flexibility for “surge” expenses that aren’t normally projected. I’ve appeased my worried wife about this, saying, “if we really need something big, or want to do something big, then I’ll just work a little bit to cover it.”
Seems like a reasonable solution to me.
Eric
Thanks for this post. It’s super helpful for me because I do plan to have paid off rentals generating a good chunk of my retirement income. Of course you can’t 100% count on ongoing income either, especially if you plan to be earning it actively.
On the other hand though, though the 25x expenses rule of thumb doesn’t scare me because most retirees DO have a lot of flexibility in their spending. Many will slash discretionary costs when the market is down (gifts, big trips, meals out). Also that’s one argument for holding at least a year of retirement expenses in cash: to avoid selling in downturns.
No number will ever be exactly reliable since there are so many variables that fluctuate so dramatically when mapped over many decades (inflation, market returns, family changes, etc). But all we can do is figure out our best guess and try to live life to the fullest. It’s too easy to err on the side of thinking you need much more than you do though, which is what I’m hoping to avoid!
Elizabeth recently posted…How Much Do You REALLY Need to Retire?
Elizabeth,
Totally agree with you on the many rules of thumb and equations out there. This number is really just a best guess, and will be revised repeatedly leading up to calling it quits. What’s more, the ability to generate income passively is pretty strong, so that can have a huge effect and is still a big unknown for me.
Thanks so much for commenting!
Eric
Nice article. I don’t trust the 4% rule for early retirement, the inflation adjustments will add up big time down the road. One thing that is different from those of us in the ER/FI community is our ability to get a grip on overspending and socking away a lot of our income, so I don’t think it would be entirely necessary to automatically adjust income for inflation each year. I’ll check out your site, but curious on your take of dividend growth investing as a hedge on inflation. My plan is to live off the dividends and the increase in dividends will be my inflation protection.
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BAMFMoney,
Totally agree on the inflation. In fact, I wrote an article a long time ago that brought up average spending across ages, and how inflation doesn’t really impact retirees all that much due to a slower lifestyle and the expense mix. Here’s a link to it (http://www.retire29.com/will-my-expenses-grow-after-i-retire/) if you are interested.
Eric
Thanks for such a great article! I have coincidentally spoken about that on my last post yesterday. Thought you might be interested http://www.myricketyroad.com/2015/11/23/how-much-much-do-i-really-need/
Cheers
MrRicket
MrRicket recently posted…How much much do I really need?
It’s definitely a question that most all bloggers explore at least once. Mainly, because it’s so important. The answer seems to always be about the same, though, with just minor tweaks depending on who you ask.
Eric
I am retiring from full time work this year at 49 years old. We’re well under the 4% rule and when Social Security starts in the future, we should be even lower.
Who knows what the “safe” withdrawal rate will end up being for us. Only time will tell us, and by then it will too late (if you err in your assumptions). Instead of trying to set a SWR now that would apply for (hopefully) many decades, we’ll keep an eye on our portfolio and adjust spending as needed. I fully expect our spending (after adjusting for inflation, of course) to go down as we age – although we haven’t budgeted it into our plans.
Bottom line: create a plan, monitor it periodically and be prepared to make a few tweaks as needed. Don’t worry about trying to figure out what will happen over the next decades. No one knows what the market will do next week, much less for the next decade (or two, or three….).
Great post.
John
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