In 1998 three professors of finance from Trinity University (in San Antonio, Texas) published a very influential paper, which is often referred to as the Trinity Study. This study was looking to determine a “safe withdrawal rate” from retirement portfolios that contain a mix of stocks and bonds. They looked at all historical stock market average returns data for every 30 year period (30 years being the standard estimate of the years post retirement for financial planning purposes). They concluded that if you withdrawal 4% of your portfolio value in the first year of retirement, and 4% plus inflation every year afterwards, you would reach the end of every 30 year period in history without running out of money. This was the birth of the “4% Rule”.
Now most of you will be early in your personal financial journeys and find the safe withdrawal rate for retirement income to be a bit too far in the future to matter, but you would be wrong. The 4% Rule has many aspects that are of great value to you now and as you move forward.
When it comes to personal finance you can’t ignore math for very long, but we will keep it simple. Another way of looking at 4% is: 1 / 25 = 4%. If you know how much money you need to cover your Expenses and Living then you can figure out how much money you need to save up for retirement.
Let’s say you need $40,000 a year to cover all of your Expenses and Living costs.
$40,000 * 25 = $1,000,000
In other words you would need to save $1 million dollars to be able to retire on $40,000 per year.
To prove I didn’t pull a fast one on you:
$1,000,000 * 4% = $40,000
(Break out those calculators and keep me honest!)
For every $1,000 of ongoing expenses you will need to save up $25,000 for retirement, so the lower your expenses the less money you need to save. The less you spend now the more you have to save and invest. This is how you can super charge your path to Financial Freedom.
Many people may wonder at the value of trying to negotiate for lower rates for monthly expenses like internet or cell phone packages. If you reduce a monthly bill by $10, you “only” save $120 per year. But if you take it one step further, that $120 a year is $3,000 you don’t need to save for a sustainable retirement ($120 * 25).
At the end of the post LWYM: Buffer and Saving we started to discuss the idea of Gap. This Gap is the money left over from your income after you cover your Expenses and Living. It is the Gap that you will be Saving and Investing. When you take your Gap and divide it by your Income you get your “Savings Rate”, which is the percentage of your income that you are saving. Combined with the 4% Rule your savings rate changes your perspective on your personal financial journey in a very profound way.
In his post, “The Shockingly Simple Math Behind Early Retirement”, Mr. Money Mustache (MMM) is kind enough to do all the math heavy lifting for us. There are a few assumptions involved in these calculations such as: 1) Your current Expense and Living costs will be the same as your Retirement requirements; 2) You can earn 5% investment returns after inflation during your savings years (conservative estimate); and 3) You’ll live off of the 4% safe withdrawal rate after retirement, with some flexibility in your spending during recessions. The following are some of the amazing results:
- Savings Rate of 10% will allow you to retire in 51 years
- Savings Rate of 30% will allow you to retire in 28 years
- Savings Rate of 50% will allow you to retire in 17 years
- Savings Rate of 65% will allow you to retire in 10.5 years
I encourage you to visit the link to get a deeper understanding of this perspective.
For those of you who are thinking that Saving and Investing 65% of your after tax income is impossible might be surprised to learn that my Wife and I are usually around the 68-70% range (including our aggressive mortgage reduction). We do both make nice salaries, which helps, but this isn’t the greatest factor in our Savings Rate: it is the choices we make.
5 years ago when we were looking to buy a house we had many choices in front of us. We looked at how much money Banks would be willing to lend us, and we looked at our Income vs Spending and decided that we were not comfortable borrowing that much money. The monthly payments would have been very high and prevent us from being able to manage emergencies as they come up. We also both work in an industry where job stability at our level is an illusion. As a co-worker of mine once said: “In our job if you are over 30 and haven’t been downsized…you’re next!”. So we planned our finances, and therefore our house purchase, around being sustainable on a single income.
With a firm limit on the price range for our house purchase, we made other choices: 1) Must be fully detached (my primary criteria); 2) Good flow and line of sight on main floor (both of us prefer an open concept approach); and 3) Must be our “final” home (we did not want to “upgrade” in a few years). So what did we have to be more flexible on? Location. We both would have loved to be in a nice established neighbourhood in Toronto, but with the above choices it wasn’t possible. We made sure that the location we looked for had good transportation to Toronto, and all the local amenities we would need. And as a result we found our home an hour commute north of the city (travelling by Go Train).
I was already working towards Growing the Gap and increasing my Savings Rate before I met my Wife, and had run across the above post by MMM shortly after we started dating. So the idea of making our choices count and being aggressive about keeping our monthly Expenses, Living and Mortgage Payments low was only logical.
For the Millennials and Post-Millennials (really need a better name for you guys and gals) out there, you are no doubt hearing a lot of people say that unless you get a huge inheritance you will never own your own home. This is a load of crap. Owning a home is a choice, for sure, and it comes with consequences, but it is absolutely possible. If you LWYM, focus on increasing your Savings Rate, and make smart choices with your finances you can own a home and still retire comfortably.