How To Retire Using This Number
Hello dear,
First, an apology.
I’m sorry I haven’t replied to all your comments/ e-mails recently.
Right now, 95% of my time is spent reading finance books and blogs. The other 5% is spent on everything else (like listening to podcasts, eating, sleeping, working out, meditating, and this little gem).
Fortunately, I’m almost done with all the reading.
Every comment and e-mail will get a reply soon. Pinky promise.
Anyways, enough apologies. You want to learn. I’m wit’ ya.
Let’s move on to today’s letter.
The 4% Rule
If you’ve read some of the blogs and books I recommended, it probably didn’t take long to find the “4% Rule.”
Sidenote: In fact, Mr. Money Mustache has a great post on the topic. Highly recommended.
But what is this mysterious “rule” everyone speaks of?
To find our answer, let’s go back to the time I taught you how much money you need to retire:
Find out how much you spend every year and multiply that number by 25. If I gave you that amount tomorrow, you’d never have to work a day in your life again.
For example, let’s say you spend $40,000 every year.
$40,000 * 25 = $1,000,000
If you spend $40k a year, you’ll need $1 Million to retire.
How do I know this? Thanks to the Trinity Study.
The Trinity Study
So, what is this?
It all started with three PhDs (Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz).
In 1998, they wanted to know how much money investors should plan to withdraw annually from their portfolio.
The idea is that if you withdraw too much, you’ll run out of money. If you withdraw too little, you’ll lower your living standards.
So, what’s the Goldilocks amount?
Luckily, they studied all the possible combinations for us!
You’ll find the main results in the table below.
Sidenote: Little trivia. Since they were Trinity University professors, their study became known as the “Trinity Study” (you can find the original 1998 document here, and the 2011 updated version here).
By the way, this table doesn’t show the full results. I decided to only show the numbers that are 100% likely to succeed (adjusted for inflation). For full results, check the study.
I know it looks at bit complicated the first time you see it.
Don’t worry. Take your time. Once it “clicks” it’s very easy to understand.
To help you, let’s focus on my personal favorite part (highlighted in green):
- 75% Stocks/ 25% Bonds.
- Withdraw 4% every year.
- 30 years time horizon.
- If I start with $1 Million, I will have $5,968,000 after 30 years.
Of course, these numbers are just approximations. But they’re good ones.
Feel free to look around (your ideal portfolio/ withdrawal rate might be different.).
The table is all yours (thanks, Trinity Study!).
Keep In Mind
If you want to withdraw 4% every year, here are a few things to remember:
1. This Lasts Your Whole Life!
I know the study results show a maximum of 30 years. However, if you retire early, you want your money to last longer than that.
Don’t worry! The length of your retirement barely affects the calculations.
If you only spend 4% (or so) of your net worth every year, you’ll have enough money to last a lifetime!
“There is very little difference between a 30-year period, and an infinite year period, when determining how long your money will last.” — Mr. Money Mustache
Let that sink in.
2. You Have To Invest in Low-Cost Index Funds
Keep in mind these results won’t apply if you don’t invest in low-cost index funds.
Why? Because you cannot remove 4% of your money if you’re already giving away 1% or more to a financial advisor.
That would be financial suicide.
Hence why it’s very important to get familiar with your new best friend, Vanguard.
3. You Must Invest in Stocks
As you can tell from the table, you cannot remove 4% every year if you have less than 50% of your money invested in stocks.
Also, the more you invest in stocks, the higher your returns will be (by far!).
Embrace the volatility.
4. Re-Invest Dividends
What are dividends? Basically how much you get every year from investments.
Sidenote: To find out the dividend, simply Google the ticker (for example, “VTSAX”) and look at the part that says “Yield”. That’s how much they’ll pay you.
Why should you re-invest dividends? Because they’re likely lower than 4% (for example, as of this writing VTSAX pays only 1.92% in dividends).
All dividends, interest, and capital gains distributions will be re-invested into your portfolio.
Dealing With Risk
The 4% rule does come with some risk (for example, during a financial crash like 2008, withdrawing 4% wouldn’t have been the best idea).
However, I don’t worry about this.
Here are a few reasons why:
1. Assets Can Be Sold
If a financial crash happens while I’m retired, I can sell some assets and survive.
2. Never Stop Working
The study assumes you’ll only live off of your investments.
However, I have never heard of an early retiree who stops working completely (they’d die of boredom).
There are too many problems out there waiting to be solved:
- How can I memorize geographical locations the way I memorize financial facts?
- How can I trick my brain into thinking broccoli tastes like chocolate?
- How can I domesticate a pet panda?
These are just some of the problems that keep me up at night. What’s more, if I solve them I’m sure a lot of people would pay me for my solutions.
Even after retiring, chances are you’ll never stop making money.
3. Adjust
Luckily for us, we’ve already learned how to live on as little money as possible.
If times get rough, just swap the organic food for ramen noodles.
“4% is only a guide. Sensible flexibility is what provides security.” — JL Collins
“But I don’t want to be flexible! I only want to live off of my investments!”
I hear you.
If that’s the case, your ideal number is 3%.
The 3% Rule
Those of you who paid close attention to the table might have noticed that the 3% column looks reaaaaally good.
In fact, it is.
If you withdraw 3% every year, you can be sure you’ll never run out of money or encounter problems.
However, there’s one little issue with choosing 3% instead of 4%.
For example, let’s say you spend $40,000 per year:
- If you use the 4% rule, multiply how much you spend by 25 to find the amount you need to retire ($40,000 * 25 = $1,000,000).
- If you use the 3% rule, multiply how much you spend by 33.3 to find the amount you need to retire ($40,000 * 33.3 = $1,332,000).
So there it is, if you use the 3% rule, you’ll need a lot more money to retire.
But you’ll be absolutely safe.
The choice is yours.
How To Get Your Money
So, how will you get your 4% every year?
Easy.
Log into Vanguard (or call them) and transfer the money from any of your investments (for example, VTSAX) to your checking account.
Sidenote: I wouldn’t set up automatic transfers and forget about it (if the market goes down, the last thing you need is to have 4% automatically removed from your investments). Remember, adjust.
Here’s Some Great News
I know I made 4% sound scary. But it’s really not a big deal.
Here’s a great fact:
Most of the time, you can remove more than 4% and still be fine.
Sure, when the market goes down, you need to adjust. But those are the very very rare events.
The normal scenario is this: You can remove 4%, 5%, 6%, 0r up to 7% and still be fine! (anything over 7% is financial suicide).
“If you gave up the inflationary increases and took 7% each year you would have done just fine 85% of the time. […] In fact, the authors of the study suggest you can withdraw up to 7% as long as you remain alert and flexible. That is, if the market takes a huge dive, cut back on your percent and spending until it recovers.” — JL Collins
On that positive note, that’s it for today!
Today, you learned about the 4% rule, where did it come from, why it works, and what other options you have depending on your preference.
See you next week (follow the series here to be notified).
Be well.
R
Since I write about finance, legal jargon is obligatory (because the guys in suits made me). Before following any of my advice, read this disclaimer.
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