We need a target to aim for:
The 4 percent rule gives us that.
The Trinity Study has worked out that the safe withdrawal rate from a US share and bond based pot is 4% per year (inflation-adjusted).
This works out as a pot that is 25 times your yearly expenses. Save that up (plus a bit for added confidence) and you’re free.
What is the Safe Withdrawal Rate?
The Safe Withdrawal Rate (SWR) is the rate that you can withdraw from your portfolio every year that ensures you have a high probability of never running out of money.
The 4% refers to the portion of the portfolio withdrawn during the first year.
It is assumed that the amount withdrawn in subsequent years will increase with the consumer price index (CPI) to keep up with the cost of living.
The 4% rule is based on historical worst case scenarios.
What about my 70+ year retirement?
The study assumed that the portfolio needed to last 30 years.
What if you’re planning on retiring at age 30 with the potential for a 70+ year retirement.
The good news is that a 3.5% safe withdrawal rate would, historically, see you through.
“Notably, it appears that the safe withdrawal rate does not decline further as the time horizon extends beyond 40-45 years … the 3.5% effectively forms a safe withdrawal rate floor” – Michael Kitces
The key thing is the sequence of real returns. If you have a good first decade then you would be able to increase the SWR after that.
You can use the Shiller PE ratio to give you an indication of the likely market performance over the next 10 years.
See these awesome analyses by Michael Kitces:
- What Returns Are Safe Withdrawal Rates REALLY Based Upon?
- Adjusting Safe Withdrawal Rates to the Retiree’s Time Horizon
- Understanding Sequence of Return Risk
I am still using the 4% SWR for the reasons I outline below. When you look into it you may choose 3.5% or lower.
A case can be made for a 3% SWR (and is here) especially for those invested in markets outside the US.
There is even an argument for a ~1.8% SWR made here based on prevailing annuity rates.
One of your missions on the road to financial independence will be to determine the safe withdrawal rate you feel happy with. The 4% rule gives you an initial target to aim for.
What size pot will I need?
As you reduce your spending and increase your savings rate on the route to becoming Rich Enough, you will get to the point where you’ll know how much you spend in a given year.
It is likely to smooth out and be quite consistent.
Your target pot will become clear.
Feeling safe with the safe withdrawal rate
Since the path to FI involves being aware of your spending, you will benefit from:
- Knowing where spending could be further reduced (without any reduction in happiness) if required during the critical first decade of retirement
- Having the energy and time to earn more money or create assets that increase passive income
- The fact that inflation has less of an effect on low spenders
- Being debt and mortgage free so that interest rates do not effect your spending
- The fact that lower spending is very tax efficient
How can I feel even safer than that?
You can simply save a bigger pot than you need.
My personal approach has been:
- To have a cash fund covering the first few years of early retirement mitigating some sequence of return risk (the risk of market corrections during the first decade of retirement)
- To have an FI early retirement fund and a separate normal retirement fund that I do not include when calculating my SWR (this will be left to grow until normal retirement age)
- We have income that comes from investment properties alongside the passive income from the FI pot (diversifying across asset classes protects your FI cash flow)
- Our yearly spending, while lower than average, has plenty of room for reduction if required
- I do not include any Social Security / State Pension in my FI calculations
- I do not include our ability to downsize to a smaller house in my FI calculations
- I do not include any inheritance in my FI calculations
Discovering your target
As you focus your spending on only those things that truly give you fulfillment, you will discover your annual spending target.
This leads you to the pot size that needs to be saved and invested.
It can build up surprisingly quickly and surprisingly easily as you Grow Rich Enough 🙂