Mo Money's Building Wealth Blog

It’s a question that everybody asks themselves at one time or another – how much money will I need so that I can comfortably retire?

There’s a whole lot of advice out there about needing some multiple of your pre-retirement salary blah, blah, but I don’t subscribe to that method.  It’s never about what you make or have made.  It’s about what you expect to spend. 

Additionally, there are many schools of thought out there that say that we will in all probability spend less in retirement than we do when we are working.  How can that be?  Well, in retirement you might downsize your home, own just a single car, no longer need to contribute to retirement accounts, insource services because you have more time (e.g. lawncare, cleaning, home and car maintenance), no longer be supplementing your children’s income, reducing your commuting expense, etc. 

And it’s also common that we wind down our spending as we age.  One of my favorite lifestyle sayings goes something like –

Your 60’s are your GO GO years.

Your 70’s are your SLOW GO years.

Your 80’s are your NO GO years.

So, to try and determine how much money you need at retirement it’s a better bet to base it on what you can realistically project your expenses to be in retirement.  Obviously, you can never be 100% certain what your expenses will be but one approach that works well is to try and create a retirement budget –

Critical exercise:  Create a retirement budget based on your predicted expenses:

• Look at year end credit card and\or bank statements for the last few years to get an idea of your spending history.
• Eliminate any job related expenses (clothes purchases, commuting, etc.).
• Add line items for retirement related expenditures like hobbies and travel.
• Assuming that you already have an emergency fund of 3-6 months expenses set aside you will probably stop contributing to your savings or retirement accounts, so leave them out.
• Reduce your expenses by any income, if any, that you can expect during retirement (social security, pension, alimony, rentals, etc.)

Once you’ve estimated how much you’ll need per year you can do some simple math to tell you how much saving you’ll likely need to fund your retirement.  There’s a favorite rule of mine know as “The 4% Rule” and its close cousin and converse, “The 25X Rule”.  I will explain the differences but for the purposes of this discussion let’s consider them the same rule based on the following assumptions by its creator, back in 1994, Bill Bengen:

• Derived from 60+ years of stock market data.
• Assumes a retirement portfolio of 50% common stocks and 50% intermediate term Treasury bonds to insure sustainability.
• Withdrawals after year 1 are adjusted for inflation.
• A life expectancy of a minimum of 30 years.

Note:  Expense figures used in the following calculations should be adjusted to reflect any expected income such as Social Security, Pensions, Alimony, Rents, etc.

The 4% Rule

The 4% rule states that once retired you can safely withdraw 4% of your retirement portfolio in the first year and then the same amount in subsequent years, adjusted for inflation.  For example, if you have $1,250,000 in retirement savings then in year 1 you can withdraw $50K ($1,250,000 x .04 = $50,000).  In the following year if inflation is 3% then the withdrawal amount would be $51,500 ($50,000 x 1.03 = $51,500).

The 25X Rule

The 25X Rule states that you should save a multiple of 25 times your projected yearly retirement expenses by the time you retire.  For example, if you project a requirement of $50K per year in retirement expenses then this rule recommends that you have $1,250,000 at time of retirement ($50,000 x 25 = $1,250,000).  It’s really just a derivation of the 4% rule as 4% x 25 = 100%.  It is intended to be a more “savings focused” approach to how much you need – i.e. what do I need to save and what size portfolio will that look like.

This is a very high-level introduction and summary of these popular rules and not meant to be an exhaustive look at every pro and con.  Nothing is a guarantee and there will always be some types of risks.  I think the key takeaways from the 4% and 25x rules are that they are simple and straightforward calculations and best used as approximations and guidelines.  Use these as a gauge of how close you are to achieving your financial goals for retirement.  If you’re not close, then you’ll either have to start adjusting your expectations or you’ll have to buckle down and start earning and/or saving more.

In a future post we’ll take a closer look at retirement savings and suggest some free online modeling tools that offer a more modern take on the 4% rule as well as some additional perspectives developed in the time since Bengen’s original study.