“You really don’t need to begin saving for retirement before you reach 60. At that point, simply save 250 percent of your income each year and you’ll be able to retire comfortably at 70.” Jonathan Pond
If you were to guess how much you needed to retire indefinitely how much do you think that would be?
- One million dollars?
- Two million dollars?
- It depends upon how long your retirement is going to be for?
Well it depends upon two simple things:
- The amount of money you need to spend each year to sustain your life,
- A withdrawal rate that will not diminish your savings over time (safe withdrawal rate).
This can be expressed by a relatively simple equation:
When you save the amount above you have enough money to buy your freedom. You have reached financial indepenence.
If the safe withdrawal rate is going to make your savings last forever it needs to be less than the average long term return of the asset classes you invest in to account for the variability in their return from year to year.
Some historical returns of different asset classes is given below:
|Asset Class||20 year historical return|
|Global Shares (hedged)||7.6%|
|Global Bonds (hedged)||7.7%|
To work out an appropriate safe withdrawal rate, it’s useful to refer to a study done by a guy called William Bengen, which you can read about here (it’s actually really good). He showed that for a historical period of 50 years that included the great depression and periods of rampant inflation that a 4% withdrawal rate would in almost all cases see your initial savings last for at least 50 years. There are some caveats of course;
- If you are unlucky enough to retire just before a major stock market crash you should probably reduce your expenditure and increase your asset allocation to stocks
- You need to get your asset allocation right (his data showed a 75% stock and 25% bond mix worked well)
- You should rebalance your asset allocation about once a year
- It’s worth noting that if you are an Australian reader you’ll have access to your Superannuation at approximately 65, in which case you could potentially use a higher number than 4% depending upon your age. (your super and non-super total withdrawal rate should still be 4% or below though)
Here’s some examples of how much money you would need to satisfy the 4% rule for different yearly expenditures:
|Expenditure per year (before tax)||Amount of money needed to retire|
Additionally there’s a great calculator here which will calculate the percentage chance of your initial savings lasting for a certain number of years based upon historical analysis of years of previous changes in asset prices with the withdrawal amount taken out each year.
Modelled for a starting portfolio of $500,000 and $20,000 expenditure per year (4% rule) where the yearly expenditure increases with CPI every year over a period of 60 years gives the following:
There is an 82.6% chance of having money remaining at the end of the 60 year period (historically). In most cases the modelling tool predicts a substantial amount of money left over at the end of the 60 years (an average of $2,700,000). For Australian readers, this also doesn’t include Super windfall which you can access at approximately 65.
However a guy by the name of Ty Bernicke did a lot of research upon spending habits as we age and found that over the age of about 56 yearly inflation adjusted spending actually decreases by approximately 2% per year. Modelling for this, assuming a retirement age of 35 and the same starting portfolio and expenditure above (4% rule) gives the following:
A 96.5% chance of success and an average portfolio size at the end of the 60 years of $3,700,000. Again this is ignoring Superannuation.
So having established that the method to determine how much money you need to retire is a function of your yearly expenditure and the withdrawal rate, which should be close to the 4% rule, it’s now time to work out how long it will take to save that amount of money and buy your freedom.
The main thing that determines this is your savings ratio, which is given by:
Coupling this with the previous equation for the amount of money needed for indefinite retirement you can see that the effect of expenses on the time you have to retire is non-linear.
Using the NPER function in a spreadsheet you can calculate the time to save enough money to satisfy the 4% rule. Here is the time to retirement for some different savings ratios, assuming the following:
- 4% safe withdrawal rate
- No current savings
- Average return on your investments per year of 7%
You can see at the Savings Ratio boundaries if you save 0% you will never be able to retire, while at the other end if you are saving 100% of your income that means that your expenses are zero and you can retire right now. Also of interest for the Australian reader is the 12% employer Super guarantee gives a time until retirement of 38.8 years, which seems close to general retirement age.
Referring back to the previous rambling, tracking your expenses and minimising them has a very powerful effect on the amount of time until you can retire.
I’m sure some are reading the table above and thinking there’s no way they can save any more than 10% of their after tax income. It’s all about priorities, do those expensive take away coffees, fancy restaurant dinners and designer clothes really mean more to you than being able to do whatever you want whenever you want? Is not having to bite your tongue with your terrible boss at your place of employment worth less to you than a new handbag?
Even with an Australian wage of $50,000 before tax, if you optimise your spending it’s possible to save above 60% of your after tax income per year and be in a position to retire in approximately 11 years.
Now that you have an understanding of the basic maths, it’s time to come up with a plan, which we’ll do in the next rambling.