In the 20th century model of retirement, people saved a nest egg over the course of a 40-50 year career. They then gradually spent down that nest egg in retirement and hoped they didn’t run out of money before they died (“superannuation,” in finance parlance).
The model raises several questions, none more glaring than “How much should I save for retirement?”
But for those who think outside the box, it also makes you wonder: “What if I want to retire young?” How does it change the math, and how can you reach financial independence early?
As you start planning your financial endgame—regardless of your current age—consider the following your five-minute crash course in retirement planning.
Safe Withdrawal Rates for Paper Assets
The old model for retirement planning generally stuck to paper assets such as stocks and bonds. Over time, retirees sold off their portfolio of assets in order to fund their living expenses.
Which begs the question of how much of your portfolio you can safely sell off each year, referred to by financial planners as a safe withdrawal rate.
Back in the 1990s, financial planner Bill Bengen reviewed how stocks and bonds performed over the last century and determined that a withdrawal rate of 4% of your portfolio would have consistently left your nest egg intact for at least 30 years of retirement. Thus the 4% rule was born.
To clarify, that’s 4% of your nest egg in the first year of retirement, followed by a small cost-of-living adjustment each year thereafter to keep pace with inflation—not 4% of your portfolio’s current balance in any given year.
You can invert that math to come up with a target for your retirement savings. By multiplying your target annual retirement income by 25, you can calculate how much you need to save if you plan to follow the 4% rule. For example, if you want to withdraw $40,000 per year from your nest egg to cover living expenses, you need $1 million (4% of $1 million is $40,000).
Find it disheartening that a $1 million retirement only yields $40,000 of annual income? I do. Fortunately, you’re not limited to paper assets.
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