When you trawl the personal finance blogs, you’ll often find reference to the “4% retirement rule”. Basically, the theory goes: “if you’ve saved 25 times your annual salary, then you can retire.” Although it’s more technically phrased as “once your retirement savings is large enough that a 4% annual drawdown is equivalent to your annual salary, then you should have sufficient savings to (safely) retire.“
The rule makes one really key assumption: that the return on your savings will be high enough that even if you draw down on some of the capital, the pot will outlast you.
So I’m putting some of these rules to the test.
Some technical notes:
- For each rule, I assumed that the savings would earn a nominal return of between 4% and 5%.
- I then varied the inflation rate that I was applying to the initial 4% drawdown amount in year 1.
- This gives you a ‘real return’, which is equal to the nominal return less then inflation.
- From there, I extended the tables of calculations through time, until the year that the savings ran out.
The key non-technical take-away: don’t worry about inflation, I took it into account.
How long will it take for the retirement savings to run out?
What you should note:
- Where the expected rate of return is equal to or higher than your drawdown percentage, you could technically live forever off the money. Basically, you’d be “living off the interest”, and never touching the capital.
- Where the expected rate of return is less than your drawdown rate (which is what you’d expect, really), then you’re skimming capital – which will eventually run out.
And the key point: with the 4% rule, even if the return on your investment doesn’t keep up with inflation, you’d still have a good 20 years or so before the money runs out.
But 20 years is not a very long time though, because life expectancy has crept up to the 90 year mark. So if you’re planning to retire early, it could all go wrong!
Planned Death Dates for Early Retirees
Here are some tables for the age at which the money would run out, depending on how much you’ve saved and at what age you’ve retired early. The redder the block, the riskier your decision to retire:
Which is exactly why most of us will work well into our old age…
The incentives to work for longer
It’s just something to bear in mind when you’re making your retirement decision. And that 4% rule really shouldn’t be used for early retirement.
After all, choosing to retire at 40 essentially means that you’re making a long-term 50 year bet on a solid economy and a stable political situation. Which seems quite risky to do with only 25 years worth of salary saved, don’t you think?
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.