How much money do you really need to retire early? I’m sure every reader here has asked that question at some point. The rule of thumb from the early retirement community is to accumulate 25x your annual expenses. This benchmark is derived from the 4% withdrawal rate. So if you have 25x your annual expenses, then you would be able to support your lifestyle by withdrawing 4% from your investment every year. That’s pretty simple, but where did the 4% come from? Is the magic 25x expenses really enough for early retirement?
Safe Withdrawal Rate (SWR)
The 4% safe withdrawal rate came from a study by 3 finance professors at Trinity University. The Trinity Study concluded that the withdrawal rate of 4% is extremely unlikely to deplete a stock-dominated portfolio over a 30 year period.
Here is how it works. In the first year of retirement, you withdraw 4% of your portfolio. Then you increase the withdrawal rate along with CPI (consumer price index) every year. The CPI is a measure of inflation released by the US government. The portfolio will get depleted over time, but it should last 30 years.
So if your expense is $50,000 per year, then you’d need about $1,250,000 in investable assets. The 4% SWR works very well for a traditional retirement. However, I’m not sure if it will work as well with early retirement. I retired when I was 38 and I hope to have a lot of years ahead of me. If I’m lucky, I could spend 50 years in retirement. That’s a long time. Would the 4% SWR work then?
25x Expenses Isn’t Enough
I’ve been retired only 4 years and I’m already skeptical about the 4% SWR. We’re doing very well financially, but we have been very lucky. I could see a very different scenario if things went south early.
I retired from my full time job in 2012 and our annual expense was at rock bottom at that point. We spent about $41,000 that year which was very low for us. We really tightened the belt to prepare for my early retirement. In hindsight, I shouldn’t have used $41,000 to measure anything because it was artificially low.
I quit my job in July 2012 when we had about 30x expenses in our investable assets. I thought that was a comfortable margin and I retired with confidence. After all, 30x is a lot more than 25x. Now that I look back, I see that a lot of things could have gone wrong.
The Portland metro CPI has been under 3% since I retired. Modest inflation is great for the economy, but the bad news is that our personal inflation has been much higher. Our annual expenses rose 30% since I retired 4 years ago! That’s about 7% annually which is more than double the CPI.
Why did our personal inflation rate rise much faster than the CPI? This is due to the dreaded lifestyle inflation. We haven’t changed our lifestyle much, but we are still spending quite a bit more money than in 2012. Here are the main reasons why.
- Preschool – When I retired in July 2012, we took RB40Jr out of daycare. He started going to preschool in 2014 and that was an added expense.
- Travel – We stopped traveling when RB40Jr was born. He’s old enough to travel now and we are taking international trips again.
- Medical – We’re on Mrs. RB40’s employer health plan so we’re not paying a lot more. It’s just the co-pays. We are getting older and we’re seeing the doctors more. RB40Jr also goes to the doctor pretty often. Kids get ear infections, fevers, weird rashes, etc…
- New stuff – We didn’t have smart phones in 2012; now we do and we can’t live without them.
The good news is that our expense seems to have stabilized and we should be holding steady for the next few years. Actually, RB40Jr is starting kindergarten next week and we won’t have preschool expense anymore. YES! I’m sure there will be other kid related expenses, though. Some of his friends are already signed up for the soccer league and they have to get uniforms, shin guards, cleats, soccer balls, and all kinds of stuff.
Lifestyle inflation is inevitable especially for early retirees. If you’re single, you might get married. If you have no kids, you might forget to take the pill and have a kid. If you’re married, you might get a divorce. People get sick and families need financial help. So many life events happen all around us and it’s amazing we haven’t had more changes. Any of these life events will do a number on your finances.
Also, there are bound to be more gadgets we couldn’t live without. Ten years ago, I didn’t need a smart phone, but I use it constantly now. New technology isn’t cheap and it’s practically impossible to avoid them. Unless you’re willing to freeze time, lifestyle inflation will push up your annual expenses. Can you imagine retiring 20 years ago and saying no to laptops, cell phones, digital cameras, flat screen TVs, Wi-Fi, and other new innovations? My father in law can do it, but not us.
I thought 30x was more than enough cushion, but it was barely enough. If I use our current expense in 2012, then we’d only have about 23x annual expense. That’s a big drop. Luckily, our net worth increased quite a bit over the last four years and we’re still doing pretty well financially.
The First Decade is Crucial
One of the biggest risks to retirement is having a few bad years in the beginning of your retirement. Imagine if you retired with 25x expenses at the end of 2007. In about a year, your stock investment would have dropped by 50%. If your investments were all in stocks, your 25x would have turned into 12x. A few bad years in the beginning of your retirement will wreak havoc on your retirement portfolio.
Luckily, I retired in the middle of a great bull market. Our investments have gained a lot of value over the last four years and now we have about 40x annual expense. Now I have a lot more confidence in my early retirement. Mrs. RB40 also plans to retire in a few years and I think we will be in a good position for that.
Early retirement means a long retirement. I could spend more than 50 years in retirement if I’m lucky. The Trinity Study looked at a 30 year period so it isn’t long enough. Does the length of your retirement impact the safe withdrawal rate? Yes, you would need to lower your withdrawal rate if your retirement is longer than 30 years. Other studies have shown that 3.5% is much better for long retirements. Half a point doesn’t sound like much, but your portfolio would need to increase from 25x expenses to about 29x.
Low Yield Environment
The 4% safe withdrawal rate was based on US historical data. They assumed 2.6% real returns for bond and 8.6% for stock. That’s not the current environment. Long term government bond yields 1.6%. Once you take inflation into account, the real return is less than zero.
Many experts are also pessimistic with the stock market recently. One way to measure the valuation of the US S&P 500 equity market is the Shiller PE ratio. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation. (via Wikipedia)
The Shriller PE ratio doesn’t necessarily means the stock market is going to crash. It is used to predict future returns from the stock market over the next 20 years. High Shriller PE ratio means your return will most likely be lower than the historical norm. As we can see from the graph, the 2016 value looks very high. We may not be able to reach 8.6% average returns for a while.
The 4% withdrawal rate has a higher chance of depleting your portfolio in this low yield environment. If you’re planning to retire today, it would be safer to lower your withdrawal rate a bit.
Here is a study from retirement researchers Michael Finke, Wade Pfau, and David Blanchett – The 4 percent rule is not safe in a low-yield world.
Improve Your Chance
Accumulating 25x your annual expense is a huge accomplishment. Most people will never get even close to that. However, you would probably want a little extra margin of safety for extremely early retirement. If you can handle working a few more years, I think 30x annual expense is a better number to shoot for. However, 25x probably would still work if you are flexible. Here are some ways to improve your chance of a successful retirement. Successful retirement in this case means not running out of money.
- Be extra vigilant in the first 10 years. The early years of retirement have outsized impact on the rest of your retirement. If things aren’t going well early on, then you may need to go back to work for a while.
- Side hustle or work part time. A little active income goes a long way in retirement. I’m working part time on my blog and the extra income shores up our retirement accounts. Early retirees should be open to income opportunities.
- Reduce cost of living. Relocating to a lower cost of living area is a great way to reduce your expenses. If the stock market is having a bad year, why not live in South America for a while? The cost of living is low and you’ll learn more about other cultures.
- Flexible withdrawal rate. Instead of withdrawing 4% and increase it with inflation, you could be more conservative and withdraw less in bad years. Withdrawing 3% in bad years and 4% in good years might work. I need to do a little more research here.
- Go over your retirement finances at least once per year. Early retirees are very diligent about their finances and I’m sure they check it more than once per year. For regular investors, the easiest way to check on your retirement finance is with Personal Capital’s Retirement Planner. It can predict if your portfolio will support your desired monthly spending. You can adjust the inflation rate, add part-time income, and see how that changes your retirement spending ability. It’s a nice tool.
We have been very lucky over the last few years, but it could have turned out differently. The stock market could have headed south or our living expenses could have shot up even higher. It’s been 4 years and we have done well so we just have to keep it up for 6 more years to get out of the crucial first decade. It would be great if we could maintain 40x expenses until then.
Image by Zak Suhar
For 2018, Joe plans to diversify his passive income by investing in US heartland real estate through RealtyShares. He has 3 rental units in Portland and he believes the local market is getting overpriced.
Joe highly recommends Personal Capital for DIY investors. He logs on to Personal Capital almost daily to check his cash flow and net worth. They have many useful tools that will help every investor analyze their portfolio and plan for retirement.
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