What is retirement rule of thumb

[Hector]

I heard some 25*X rule thumb, by which one can keep withdrawing 4% every year and money will last forever.
What is X here?
Is it yearly expense?
Is it yearly income? Net or gross?

[jIM_Ohio]

25X is yearly expense
the 4% is the initial withdraw rate (based on initial portfolio value)
and lasting forever is 30 years. If forever is longer one of two things is true
1) the market performed really well early in retirement (like a 5 year bull market of 10%+ yearly returns each year)
or
2) expenses covered are not impacted by inflation (for example fixed/controlled rent, low food and health care costs)


If you have a spreadsheet, try these numbers to prove this yourself

a) give investments a 6% annual average return (before inflation)
b) start with 40k expenses/ $1 M total portfolio value
c) raise the expenses 3% each year for inflation
d) track the withdraw percentage each year

Then create a spreadsheet
you will see with just linear numbers above, the portfolio grows for about 22 years (meaning portfolio has a higher value at end of year than beginning). Within 22 years inflation has reared its head though, and 40k of expenses in year 1 is now 74k in year 22. The investment returns of the account are 66k per year, so you can see eventually principal will get depleted. The withdraw percentage in year 22 is 6.05%, so while 4% was the initial withdraw percentage, because withdraws increase with inflation, that is NOT a fixed number for life (it increases with time).

Because 6% returns are constant in this example, you will see problems **earlier** with varying returns (what if returns were -6% a few times?). Most of the "forever" or "30 years" descriptions deal with percentages (like 95% of the times in history a 60-40 portfolio will last 30 years with a 4% INITIAL withdraw rate).


There are additional studies since the 4% rule was created which show techniques to use higher withdraw rates early in retirement. For example one study I read recently suggested a 5.5% rate can be used if expenses are cut when market drops by X% and if expenses only need the high withdraw rate for Y years. This allows people to spend more money earlier when they are younger.

Other studies show techniques like 95/5. Take 5% withdraws each year, but always leave 95% of portfolio intact (so if market has a down year, you are leaving 95% of the portfolio value intact). This technique works (IMO) when most expenses are variable. If a $1 M portfolio/ 40k of expenses were needed, then market took away 40% of portfolio (600k remains), 95% of 600k is 570k, so only 30k can be taken out that year, and that is a 25% drop in expenses.

[jpg7n16]

Originally Posted by Hector

I heard some 25*X rule thumb, by which one can keep withdrawing 4% every year and money will last forever.
What is X here?
Is it yearly expense?
Is it yearly income? Net or gross?

Mathematically, X is whatever you want it to be. By your statement, it would be withdrawals. Whether that goes to expenses, taxes, or something else is up to you, but it is what is withdrawn from the investment.

Here's how that works, and it's all based on interest rate.

So say you want to withdraw $50,000/year. Then you need to find a sum that generates 50,000 at some interest rate.

X * % = $50,000

Therefore, $50,000 / % = X.

So you just divide whatever you need to withdraw by the interest rate your money can earn, and that will tell you how much you need. The "25x" thing is just determining what you need for each dollar you want to withdraw.

$1 / % = X; And 1 / .04 = 25

That's where that 25x comes from. I wouldn't say it's really a "rule" it's just math. $25 invested at 4% makes 25 * .04 = $1 in earnings. Then that $1 is withdrawn, leaving you with $25 still. Which makes another $1 (4%) next year, which is withdrawn. You can withdraw the earnings "forever."

If you could make 5% forever (after investment expenses), you would only need $1 / .05 = 20x in order to create a perpertual stream of $1/year. (10% is 10x, and on and on)


Some problems with that "rule" are inflation and unpredictability of earnings rate. $10k a year would have been amazing in 1930. Not so much today, or in 50 more years. And depending on your investment, you may not be able to make more than 4% each and every year.

[Hector]

Thanks guys. It helped.

[jIM_Ohio]

Originally Posted by jpg7n16

Mathematically, X is whatever you want it to be. By your statement, it would be withdrawals. Whether that goes to expenses, taxes, or something else is up to you, but it is what is withdrawn from the investment.

Here's how that works, and it's all based on interest rate.

So say you want to withdraw $50,000/year. Then you need to find a sum that generates 50,000 at some interest rate.

X * % = $50,000

Therefore, $50,000 / % = X.

So you just divide whatever you need to withdraw by the interest rate your money can earn, and that will tell you how much you need. The "25x" thing is just determining what you need for each dollar you want to withdraw.

So; $1 / % = X; And 1 / .04 = 25

That's where that 25x comes from. I wouldn't say it's really a "rule" it's just math. $25 invested at 4% makes 25 * .04 = $1 in earnings. Then that $1 is withdrawn, leaving you with $25 still. Which makes another $1 (4%) next year, which is withdrawn. You can withdraw the earnings "forever."

If you could make 5% forever (after investment expenses), you would only need $1 / .05 = 20x in order to create a perpertual stream of $1/year. (10% is 10x, and on and on)


Some problems with that "rule" are inflation and unpredictability of earnings rate. $10k a year would have been amazing in 1940. Not so much today, or in 50 more years. And depending on your investment, you may not be able to make more than 4% each and every year.

If withdraws are a FIXED amount, the math above is accurate to solve problem
If returns are a FIXED amount, the math above can be used to approximate problem for planning.

When accumulating, I use the 25X number as my "target" for knowing when I am close to having enough to retire on.

Most of the planning (however) is in HOW the 25X is drawn down.
Variables
a) inflation
In example I gave initially, it needs to be clear that the money would NOT last forever, by year 22 with fixed returns and inflation indexed withdraws, it becomes clear the portfolio return does not match expenses (return is less than expenses).
b) returns
Unless the investment is an annuity, then the returns will vary, and the variance of returns becomes almost as important as inflation. Stocks return (on average) 9% per year. But the variance of the data which gives the 9% return includes -6% happening as often as +24%. If too many of those low return years (-6%-+4%) happen early enough in retirement, "forever" becomes a very short period of time.
c) portfolio allocation and length of retirement
The 25X rule and 4% rule (same thing) came from the trinity study. This study back tested all market returns over 30 year periods, and established the 4% rule based on a 60-40 portfolio (60% stocks, 40% bonds). The basic conclusion was a 60-40 portfolio could have 4% withdrawn and survive in 95%-100% of the 30 year periods tested.

Change any of those variables and 4% might not be the answer. Meaning if you want a 40 year retirement, want a 40-60 portfolio allocation, or want expenses in retirement to change based on more than inflation, then 4% is not (or may not be) the answer.

It is interesting though, that with many new studies coming out, even though they change their inputs, the 4% output is close (meaning I have seen some studies using a 95/5 rule, a change in spending rule, a market performance trigger on expenses and similar, and they all eventually conclude something really close to 4% anyway. By time the withdraw rate hits 5% in many cases the portfolios are failing quite a bit.

d) expenses
4% is based on a set amount of expenses, and increasing those expenses slightly every year in retirement to account for inflation (3% average inflation is built into the 4%). If you know your expenses in retirement will change, then the 4% is a starting point only, do NOT enter retirement without further planning if you know of new or changed expenses. examples of changes in expenses:
1) paying kids college or weddings while in retirement
2) selling a house while in retirement and buying something cheaper
3) travel when in retirement
4) increase in health care costs

e) taxes
Taxes are built into the 4% (reference trinity study). If the money being accessed is either tax free (Roth IRAs), or in taxable accounts (savings accounts, brokerage accounts outside of a tax shelter) it is very possible you can use a higher withdraw rate by up to 4.5% or maybe even 5%.

In this case use the math provided earlier to get new target... a 5% withdraw rate is 20X expenses. 1*X/.05=20X

f) detailed planning
Most people use 401ks and 403bs for retirement savings and Roth IRAs are a small portion of savings. In my case I have 200k invested right now, but only about 40k of that is in a Roth. As e) points out, I can increase my withdraw rate if I can "shift" more money to the Roth earlier in life. Detailed planning like this (doing Roth conversions) can improve chances of success. Other similar techniques would include spending the Roth money last so the tax free gains can be used for a longer period of time.

[jpg7n16]

Originally Posted by jIM_Ohio

When accumulating, I use the 25X number as my "target" for knowing when I am close to having enough to retire on.

I think that's probably the best use for that info right there. A general goal to shoot for.

Ultimately you may need a bit more or less, but yeah that's a good practical use for it.

[Hector]

How do you guys calculate your retirement #?

This is what I think:
Currently my yearly expense is X.
I still have Y years to retire.
After Y years, Z (adjusting yearly inflation of 3% for Y years) will be my yearly expense.
So my retirement # is 25*Z

[jIM_Ohio]

Originally Posted by Hector

How do you guys calculate your retirement #?

This is what I think:
Currently my yearly expense is X.
I still have Y years to retire.
After Y years, Z (adjusting yearly inflation of 3% for Y years) will be my yearly expense.
So my retirement # is 25*Z

LOL
There are times when inflation is overrated, and I think this is one of them.

Do 25X
not 25Z

that way you always measure target against current expenses
then factor inflation into draw down only.


Here is why I say this... two main reasons

A) my expenses do not change (increase) by 3% per year (yours might, mine don't). For most part they either decrease or stay the same (for example when I pay a car off in August, that money gets saved, so my expenses for 2010 will be less than 2009). If gas costs go up, we eat out less because our income is "fixed", so therefore expenses to me are fixed even if the costs of items I buy go up.

b) expenses change too much over a 10-20 year period. My expenses today at age 37 and what they looked like at 27 are really different. In retirement more things will be different. Less house, less utilities, cars from this point forward are paid for in cash, but would not be in current expenses (so more detailed planning is needed). Kids move out before retirement (you hope) and maybe eating out is more (or less) than it was when working because you have more time to cook or less desire to cook.


Factor into that if I received 25X my expenses number today (like if wife died and I collected life insurance, we hit it big in Vegas next month, or someone leaves me an inheritance), it is very possible I could retire. I need 25X of my expenses for 2010 and I am confident I could make that work.

Why?
because when you hit 25X of your CURRENT expenses, the 4% rule takes over (and the 4% factors in inflation each year once in retirement).

The only difference in the calculations would be this

a) if I received lump sum now, I am 37 yo, so my retirement is closer to 60 years than 30 years. b) I recently read a study which showed the withdraw rate for 40 years was about 3.3%. The interesting thing about this was it did not matter about portfolio allocation, whether 80-20 or 25-75, the rate for both portfolios, and the 2 tested in between had identical withdraw rates (regardless of allocation).
c) so I would need to adjust either a short term spending pattern to get 33X, wait a few years for 25X to become 33X or find another loophole to stretch what is 25X into a longer than 30 year retirement

Most smart people can adjust expenses to income. Focus on 25X of current expenses, and when you approach that, retirement is inevitable.

[jpg7n16]

Originally Posted by Hector

How do you guys calculate your retirement #?

This is what I think:
Currently my yearly expense is X.
I still have Y years to retire.
After Y years, Z (adjusting yearly inflation of 3% for Y years) will be my yearly expense.
So my retirement # is 25*Z

I kinda disagree with Jim, cause what you've described is almost how I'd do it. You forgot to adjust your X for reduced expenses (aka term life insurance that ended, disability insurance, retirement savings, effect of social security, mortgage paid off, etc.) So adjust your X down by 20-30%. 25% is a good estimate which will prob give you a number that's a bit too high.

(X * .75) * [(1 + infl) ^ (Y)] = Z

Shoot for around 25 * Z. Or shoot for 40x and you'll be just fine regardless


Example: current expenses are 50k, 25 years to retirement

(50k * .75) * (1.03^25) = $78,517

25 * 78,517 = $1.96 million

[jefffou]

Originally Posted by jIM_Ohio

Unless the investment is an annuity, then the returns will vary, and the variance of returns becomes almost as important as inflation. Stocks return (on average) 9% per year. But the variance of the data which gives the 9% return includes -6% happening as often as +24%. If too many of those low return years (-6%-+4%) happen early enough in retirement, "forever" becomes a very short period of time.

You guys did a great job of explaining something that is difficult to explain....

As for the above quote, this is why investing near or during retirement becomes a TOTALLY different kind of animal than investing for accumulation as one would do in their 30's or 40's. Many professionals make this mistake, in my opinion. They follow the morningstar style boxes and HOPE their clients are protected.

The generic 60/40 or 70/30 mix of stocks and bonds really doesn't address the problem. The problem is too much correlation within one's portfolio. And not just too much correlation, but too much correlation during times (think 2008) WHEN IT REALLY MATTERS.

For example, portfolios may be tested for correlation during good times. Or they may be averaged over a long period of time. The problem with this is that the ONLY TIME IT REALLY MATTERS is when the world's economy is falling apart and it seems like it will never end.

Corporate bonds, normally somewhat uncorellated with stock, in 2008 became VERY correlated with their stock counterparts. This was because the solvency of companies came into question. Yes, their stock prices were affected, but their ability to pay back their debts was also brought into question. Therefore both stocks and bonds corellated with one another and both fell off the cliff at the same time. Bonds, generically speaking, offered very, very little in the way of diversification when it mattered. I guess you could say that corporate bonds offered dilution, not diversification.

So, are you close to retiring? Are you retired? Figure out a way to diversify in a way that has shown to offer protection during 2001 and 2002. Find out what worked in the fall of 2008 and the Spring of 2009. That's what real diversification is all about.

Because Jim is right. If you find yourself retiring at the wrong time of the market, you may be going back to work really soon.

[maat55]

A common number to use for retirement needs is 70% of your income before retirement. As Jim stated, your expenses should be less than while you were preparing. A paid for home and investment funds are two large drops in expenses.

[MonkeyMama]

Good points made.

To put it simply, if you are young, it is pretty much impossible to predict retirement expenses. Young people under-estimate inflation. Everyone under-estimates taxes in retirement.

If you are young, aim for 25 times income. This accounts for all the unforeseens in life! Curveballs, guaranteed.

As you approach retirement, I agree with aiming for 25 times Z. Z is going to look very different for every person. I can think of a few scenarios that alter Z drastically. (Moving from a high cost area to a low cost area? Contrast that with someone who becomes disabled and retires prematurely. Maybe they are mostly prepared, but health insurance cost $30k per year for a few years until they are eligible for Medicare. I know people in all these scenarios. z may be 25% income for one, and 100% income for another).

[Hector]

I see that a couple of you are involving income in the formula, but I personally feel comfortable when expense is in the formula because these days jobs and salary is changing/fluctuating a lot and one can control and have somewhat stable expense patterns compare to income patterns.

[jIM_Ohio]

Originally Posted by Hector

I see that a couple of you are involving income in the formula, but I personally feel comfortable when expense is in the formula because these days jobs and salary is changing/fluctuating a lot and one can control and have somewhat stable expense patterns compare to income patterns.

A common number to use for retirement needs is 70% of your income before retirement. As Jim stated, your expenses should be less than while you were preparing. A paid for home and investment funds are two large drops in expenses.

When you see this, that 70% accounts for spending, its just another way of saying spending by suggesting 30% of income is either taxed (FICA) or saved or spent on an item not needed in retirement.

Most people spend what they earn, so those 70%-80% guidelines are accurate.

If you track expenses and use expenses, you can plan better.
You will know what expenses go away (like commuting to work and clothes for work)
and what expenses might increase (hobbies, travel)

[disneysteve]

Originally Posted by jIM_Ohio

Most people spend what they earn, so those 70%-80% guidelines are accurate.

If you track expenses and use expenses, you can plan better.
You will know what expenses go away (like commuting to work and clothes for work)
and what expenses might increase (hobbies, travel)

Agreed. We currently live on a little over 50% of our gross income when you subtract out taxes and savings. That 50+% includes expenses that won't all exist in retirement, like the mortgage payment, so when you knock that off, we actually live on less than 50% of income. That should make reaching the point at which I can retire a lot easier. At least that's what I'm hoping.

[jpg7n16]

Originally Posted by Hector

I see that a couple of you are involving income in the formula, but I personally feel comfortable when expense is in the formula because these days jobs and salary is changing/fluctuating a lot and one can control and have somewhat stable expense patterns compare to income patterns.

Just remember that these are all estimates anyways. No one knows exactly how much you need because of all sorts of variables. Life isn't fixed, so even expenses can and will change during retirement.

Like Jim said above, since most people base expenses off of income, the 70-80% adjustment is an estimation of expenses as it relates to a percentage of income. Steve would use a 50% adjustment in his calculation.

When I calculate, I choose a slightly higher income and a slightly higher expense ratio. Both of those would require a higher target for me to shoot for. I'd rather save a bit too much, than a bit too little.

[disneysteve]

Originally Posted by jpg7n16

When I calculate, I choose a slightly higher income and a slightly higher expense ratio. Both of those would require a higher target for me to shoot for. I'd rather save a bit too much, than a bit too little.

I agree. My goal is not to replace what we currently live on. I want to have a higher disposable income in retirement so I'm shooting for 70-80% just like everyone else. I'm just hoping I'll have an easier time reaching that point since we only live on 50% now.

[MonkeyMama]

Originally Posted by Hector

I see that a couple of you are involving income in the formula, but I personally feel comfortable when expense is in the formula because these days jobs and salary is changing/fluctuating a lot and one can control and have somewhat stable expense patterns compare to income patterns.

Good point.

I actually would probably use expenses to guage retirement needs (our income too has been far more volatile than expenses). I suppose I should have said, the younger you are the higher you should aim for. Using income was just an "easy" answer. But now that I think about it, might not make much practical sense to many people. Certainly not me.

I am aiming for "expenses" times a higher factor than 25, while in my young 30s. I'll put it that way!

[TrunkMonkey]

Most of the advice here and from advisors advocating 4% withdrawal seem like scare tactics and totally unrealistic. Also advice you get from online calculators usually overestimate the savings needs for most retirees.

You can judge your own needs better then anyone else.

If you want a guaranteed withdrawal for life just buy an annuity. You can get a guaranteed rate ~6.5% if you are 65. Spend this or stagger it and buy another later in 10 years - use this for your basic expenses.

That is one option to beat 4% withdrawal rate.

[Seeker]

Originally Posted by TrunkMonkey

Most of the advice here and from advisors advocating 4% withdrawal seem like scare tactics and totally unrealistic. Also advice you get from online calculators usually overestimate the savings needs for most retirees.

You can judge your own needs better then anyone else.

If you want a guaranteed withdrawal for life just buy an annuity. You can get a guaranteed rate ~6.5% if you are 65. Spend this or stagger it and buy another later in 10 years - use this for your basic expenses.

That is one option to beat 4% withdrawal rate.

And buying an immediate annuity has expenses that are related to the management of them. Many people lose money in the long run and would be better off just putting their money in savings (and retaining their principal).

I suppose you can purchase an immediate annuity for a guaranteed rate of 6.5%, but how much will it cost you? How much will each payment return? Add up all the "returns" until you reach the amount paid in. How long will that be?

The principal (purchase) immediately becomes the property of the investment firm (it's not in anyone's best interest to buy an annuity from an insurance company -- investment company's annuities are usually better products), and there are tax considerations as well.

People lose money by not managing their own financial future.

The money used for the purchase, management, etc for annuities, almost never get returned 100%. Ask what the payout rates are. Count them up. And know that even without inflation and all the other invisibles, you will never get all your money back from purchasing an annuity.