By The Pointer
One of the things we talked about in Step 1, was defining “enough”. In other words, “How much money do you really need to be happy?” That’s a tricky question to start with so we simplified it to, “How much money do you spend on your current lifestyle?” To work with an example, I’d like to introduce you to Travis. Like you, he wants to pursue financial independence, but he’s not sure how to start. He just knows that he’s currently spending $60,000 per year excluding taxes (which was also the US household average in 2017 according the Bureau of Labor Statistics).
How can you predict how much money you’ll need in the future?
The short answer to this question: you can’t know how much money you’ll need. Unless you have a time machine or you’re secretly an oracle, you’ll have to make some assumptions and live with some risk. Travis is in the same boat. Let’s see how simulations from past market data can help him estimate what he’ll need.
The 4% “Rule”
In 1994, William Bengen looked at the historical market data (stock and bond market) to estimate how long a retiree’s portfolio would last based on various withdrawal amounts. He found that these retirees never ran out of money over a 30-35 period if they had a 50% stock/50% bonds portfolio and a 4% withdrawal rate.
What does a 4% withdrawal rate mean? Let’s say you have $1,000,000 ($500,000 invested in S&P 500 stocks and $500,000 invested in intermediate term government bonds), then you can safely withdraw 4% of that amount or $40,000 in year 1, and then adjust that withdrawal amount for inflation each year. In year 2, you would withdraw $40,000 plus the rate of inflation over the past year. In other words, if inflation was 2%, then you’d withdraw $40,000 + ($40,000 x 2%) = $40,800.
In 1998, the Trinity study was published. Like the Bengen study, it looked at safe withdrawal rates, but with more data and a different data set on past bond returns. It had similar findings: based on historical data, a 50/50 stock/bonds portfolio lasted 30 years in 95% of the simulations.
Between these two studies, the 4% withdrawal rate became known as the “safe withdrawal rate” or the “4% rule”.
Why do I have to buy stocks in all of these scenarios?
In both the Bengen and Trinity studies, they specified that the theoretical retiree they were modeling had to have a certain amount of their portfolio invested in the stock market. Why is that? Well, it’s because the US stock market has an excellent track record of going up in value over time. One share of stock is basically a small ownership stake in a company. As that company makes money, you’re entitled to a piece of that company’s value.
Many people freak out about the idea of owning stocks. They see them as too risky. Sure, buying any one company is risky. All it takes is one bad decision or a corporate scandal to tank the company. That’s why most people pursuing financial independence invest in mutual funds that buy shares of the entire stock market (ie. owning a piece of the entire stock market; not just a few individual companies). While it’s very risky to invest everything you have in one company; risk is reduced when you own nearly every company on the market. The chances of all of them failing at the same time is very low.
In fact, the stock market is a huge wealth creation engine. While it has ups and downs, it has been a remarkably reliable investment over time.
Between 1871 and the end of 2018, the total return of the S&P 500 (an index that measures the combined performance of 500 of the largest companies in the US stock market) was 6.9% per year (adjusted for inflation and factoring in reinvested dividends). Even if you don’t trust early stock market data, returns are similar over other long periods. From 1926 through 2018, returns were still 6.9%. From 1950 through 2018, returns were 7.4%. Total real stock market returns have historically been around 7% per year. Past performance isn’t a guarantee of future success, but it’s a decent estimate backed by years of data so you’ll see me referring to this 7% per year return in the rest of this series.
How can I predict how much money I’ll need for financial independence?
Let’s go back to Travis. He’s spending $60,000 per year. If he plans to continue spending that amount, and expects to use a 4% withdrawal rate, then he’ll need:
$60,000 ÷ 4% = $1,500,000
$1.5 million seems like a lot. It is, but keep in mind that we haven’t tackled the ways that Travis can decrease his expenses or increase his income yet. Remember, the definition of “enough” changes throughout this journey. Plus, we know that as you he invests his savings, the money in those investments will grow without any work required on his part.
The limitations of the 4% “rule”
Don’t get me wrong. There are a lot of reasons to use the 4% withdrawal rate for financial independence planning. It’s the withdrawal rate I used myself. However, I put the word “rule” in quotes for a reason: it is often taken as a sacrosanct law when it’s not. I have to credit Early Retirement Now and his Safe Withdrawal Rate series with showing me the biggest limitations:
- What if your retirement horizon is more than 30 years? – The Bengen and Trinity studies looked at 30-year retirements. People pursuing FI often “retire” at young ages. We could be looking at 60+ year retirements. Does the 4% rule hold up over a long period like that? The answer is “yes” if we’re willing to take on additional risk. While the 50/50 stock/bond portfolio has a 95% success rate over 30 years; it’s only 65% over 60 years. Meanwhile, a 100/0 stock/bond portfolio has a 99% success rate over 30 years and an 89% success rate over 60 years. That’s not bullet proof, but it’s still tolerable to me. If it’s not tolerable to you, consider a lower withdrawal rate.
- Isn’t a 50/50 stock/bond allocation really conservative? – Yes. See bullet point #1. Your portfolio is more likely to survive over long periods of time with a greater stock allocation. Historically speaking, bonds will earn less than 4% per year and stocks will earn more. The more you have in bonds, the smoother the ride (they’re less volatile), but they’re a drag on earnings.
- What about taxes, fees and other transaction costs? – Outside of spreadsheets, most people aren’t able to keep 100% of their earnings. Real people have to deal with mutual fund expenses, financial advisor commissions and the tax man. However, when we get further in this series ((Legally) Avoiding Taxes and Investing Your Savings), you’ll see how these factors can become negligible or non-existent.
How long will it take to hit my financial independence target?
Now, we have a starting point. Travis needs at least $1.5 million in 100% stocks to be prepared for 60 years of financial independence. How long would it take to reach that point? Well, it largely depends on his saving rate. Below, you can see how your retirement horizon changes drastically based on your post-tax savings rate.
Let’s say Travis’s current savings rate is at the US average, 6%. Well, that would mean it’ll take him 49 years to reach financial independence. That would make him 79 at the time, which is also life expectancy for men in the United States. In other words, he’d die about the same time he’s ready to retire, which is why retirement seems out of reach for so many.
What if Travis reads the next few installments in this series, which help him to reduce expenses (including taxes) and increase his income? If he can get his savings rate to 30%, he’s only 24 years from FI. With a 50% savings rate, he’ll be 15 years from FI. If he gets all the way up to the 70% rate I was at, it’ll only take him 8 years. This all depends on several variables, most of which he can impact: income, expenses, taxes and savings/investments. Let’s start getting into how he (and you) can start optimizing these categories.