This evening I was looking at my facebook feed and this article on why the 4% rule only works for the wealthy popped up.
After reading the article and comments, it reminds me how much people need to learn about basic math and finances. Sadly, many of these articles are doom and gloom and don’t provide any of the easy solutions that FIRE proponents advocate.
Simply speaking the 4% rule applies to everyone as long as you adhere to the math. So what math is that you ask?
It basically boils down to two factors: Earning and Spending. Lets start with spending first and then move on to earning.
Determining your spending:
Before you can reach your goal of financial independence you need to know where you are. In order to do this you need to track your spending. Personally, I use mint.com to track my spending. It lets me see my “fixed” monthly debt (mortgage payments and student loans) and my other expenses- utilities, groceries, child care, leisure/extraneous spending. Looking at these gross numbers you can get an idea of what your annual spending is, some of this will change with retirement (that is one thing the above article got right).
Let’s just say that my anticipated expenses will be 50K a year based on my current spending and the wife and I make 120K a year- this should give me some wiggle room since I should not have child care, mortgage, and student loans, but I may have other medical expenses (hopefully, not).
Figure out your expected earning rate (return rate):
How much do you expect to earn, and how that helps you reach your retirement goals.
Now you have to decide how much you expect to earn off your investments. For the sake of argument let’s anticipate a 7.94% stock return on average and a 4.06% bond return loosely based on the the following link: average http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histret.html
So if I decide to leave 80% of my money investments in stock and 20% in bonds I can expect the following return:
80% x 7.94% stock return + 20% x 4.06% bond return= 6.35% + 0.81% =7.16%
If we expect that up to 3.1% of our money would be taxed or loss to inflation (unlikely given current environment and other vehicles like Roth IRA and HSA) that gives us a 4% earning on our investment.
Figure out your nest egg number:
Based on the 4% rule how much do we need to retire:
Total Retirement fund x earning rate= spending amount
TRF x 4% =$50,000 in our scenario
We would need 2.0 million in order to retire taking into account inflation based on our scenario. It seems like a lot, but it really is not that much once you take in the power of compounding interest. (it is even easier and you likely need an even lower number if you optimize your IRA, Roth, HSA, etc).
Figure out how long you need to keep working:
So let’s run the math on this to figure out how long we need to work in order to retire:
If we start at 0 and put away 70k (120k-50k) a year at earn 4% on it post inflation and taxes it would take us 19 years based on compounding interest calculators.
I used this calculator to help me with the math: http://www.moneychimp.com/calculator/compound_interest_calculator.htm
This same math works for everyone regardless of if you are “poor” or “rich” in the article.
Of course if you don’t want to save this much you have a couple options:
1. Increase earning:
A. You can continue to work part time during retirement- rental income, part time work, etc. This will reduce the money you will need to take out from your investments so they can continue to grow.
B. Change your investment allocations: i.e. increase the proportion of money you have in stocks since they have higher returns. The downside is the relatively higher volatility in stocks, I personally plan to keep 5 years worth of spending in bonds or other “safer” investments to help me weather the storm during bear markets.
2. You can cut down your spending.
A. You can downsize your home once your kids move out and then actually invest any possible earning you have on it.
B. You can cut down your luxury expenses, and find other fun free things to do like enjoy the outdoors and/or spend time with family and friends.
Hope this posts helps put things in perspective. Let me know what you think about it and feel free to post any suggestions.