4 Percent Rule of Retirement

03 Mar 4 Percent Rule of Retirement

You may have heard of the “4 percent rule” when it comes to calculating how much you need to retire. It specifies how much money you can “safely” withdraw from your retirement portfolio without reducing your principal (i.e. the withdrawal consists of interest and/or dividends). The assumption here is you are getting a 7% annual return on retirement investment. We then subtract the average inflation of 3% per year, it gives us 4% return after inflation per year.

Now that we know where 4% is coming from, how do we know how much money we will need to save up in order to withdraw 4% each year? It depends on annual living expenses in retirement. If you are planning to spend $70,000 a year the math is the following:

$70,000 / Retirement_Portfolio = 4%
Retirement_Portfolio = $70,000 / 4% = $70,000 x 25 = $1,750,000

In other words, if you want to have an annual income of $70,000 when you retire you should have approximately $1,750,000 in your retirement portfolio. Another way to calculate this is “multiply by 25”, simply take the annual income goal and multiple by 25 to get the total portfolio number.

The important assumptions we have made here:

• The investment should be mostly in stock index funds which historically has produced a 7% return
• The inflation is about 3% a year
• The market does not suffer any huge losses
• The number of years in retirement is around 30 years

What if I want to be safer with my assumptions and adjust for higher inflation?

Modify your number for retirement and assume a 3% return instead of 4%. If you use the above math to calculate the size of portfolio needed to support the 3% return you will be “multiply by 33” instead of 25.