How much money do you really need to retire early? I’m sure every reader here asked that question at some point. The rule of thumb in the early retirement community is 25x your annual expense. This benchmark is derived from the 4% safe withdrawal rate. If you accumulated 25x your annual expenses, then you would be able to support your lifestyle by withdrawing 4% every year. That’s pretty simple, but where dd the 4% rule come from? Is the magic 25x expense really enough for early retirement?
Safe Withdrawal Rate (SWR)
The 4% safe withdrawal rate came from a study by 3 professors at the 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 smaller over time, but it should last 30 years.
For example, if your expense is $50,000 per year, you’d need about $1,250,000 in investable assets to fund your retirement. The 4% rule works very well for traditional retirement. However, I’m not sure if it will work with early retirement. I retired when I was 38 and I 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 for early retirement?
25x Expenses Isn’t Enough
I’ve been retired for 7 years and I’m skeptical about the 4% SWR. We’re doing very well financially, but we have been very lucky. It might have turned out differently if I retired at the wrong time.
I retired from my engineering career in 2012. 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 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 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 our personal inflation has been much higher. Our annual expenses rose 39% since I retired 7 years ago! That’s about 5.5% annually, more than double the CPI.
Why did our annual expense increase so much faster than the CPI? This is mostly due to the dreaded lifestyle inflation. We didn’t change our lifestyle much, but we are spending more than in 2012. Here are the main reasons why.
- Our son – In 2012, I became a stay-at-home dad and we didn’t spend much on childcare. In 2014, RB40Jr started preschool so that increased our expense. Fortunately, our public school is pretty good so that expense disappeared when he started kindergarten in 2016. We don’t have childcare expense now, but we still need to buy clothes, food, and pay for various activities. It’s harder to retire early when you have kids.
- Travel – We took a break from traveling when RB40Jr was born. He’s old enough to travel now and we are taking international trips again. Last year, we spent over $10,000 on travel. We visited Iceland for 2 weeks and Thailand for 5 weeks. This year should be much cheaper.
- Medical – We’re on Mrs. RB40’s employer health plan so we’re not paying a huge amount. 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 a smartphone in 2012; now we do and we can’t live without them. Our TV is 14 years old and I want a nicer one. There are lots of new things to spend money on.
- Increased net worth – The economy did very well since I retired and our net worth doubled. We feel more comfortable financially so we aren’t as frugal today.
From the chart above, our annual expense increased dramatically from 2012 to 2014. Then flattens out until 2018. Last year, we spent more than usual because we traveled more than normal. This year, our annual expense should drop a bit. Our housing expense decreased because we moved into our duplex. We also cut back on travel. Hopefully, we can get back under $55,000/year. That seems to be the sweet spot for us.
Lifestyle inflation is inevitable, especially for early retirees. If you’re single, you might get married. No kids? Your partner might decide to have children. Married? You might get a divorce. People get sick and families need financial help. My mom developed dementia last year and she needs a lot more help now. Life is unpredictable and you have to be flexible and adapt. It’s very difficult to keep your expense flat from year to year.
Also, there are bound to be more gadgets we couldn’t live without. Ten years ago, I didn’t need a smartphone, 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 22x annual expense. That’s a big change. Fortunately, our net worth increased significantly over the last 7 years. We didn’t draw down because our income exceeded our expense. We kept adding our investment and it worked out really well. You can read more about our withdrawal strategy in detail here. Basically, we are putting off withdrawal until we’re 55.
The First Decade is Crucial
One of the biggest risks to retirement is having a few bad years at the beginning of your retirement. Imagine if you retired with 25x expenses at the end of 2007. After one 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 at the beginning of your retirement will wreak havoc on your retirement portfolio. This is called sequential of return risk.
Luckily, I retired in the middle of a great bull market. Our investments gained a lot of value over the last 7 years and now we have over 40x annual expense. Now, I have a lot more confidence in my early retirement. Mrs. RB40 plans to retire soon and we will be in a good position for that event.
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 and that 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 30x.
If you retire at 55 or older, then the 4% rule should work quite well.
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 investment. That’s not the current environment. Long term government bond yields 1.8%. 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 mean 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 2019 value looks very high. We probably won’t get 8.6% average returns in the next 10 years.
The 4% withdrawal rate has a higher chance of depleting your portfolio in this low yield environment. If you’re planning to retire by 40, 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.
Read more about the Safe Withdrawal Rate at Early Retirement Now. Big Ern wrote a huge series on this topic.
Improve Your Chance
Accumulating 25x your annual expense is a huge accomplishment. Most normal people will never get even close to that. However, you should add a little extra margin of safety for early retirement. If you can handle working a few more years, 30x annual expense is a much safer 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 should go back to work for a while. This is the advantage of early retirement. If things don’t look good, you can fix it because you’re young.
- 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 is very helpful. Early retirees should be open to income opportunities. Retirement doesn’t mean you have to stop working completely. Develop a thick skin and ignore any negative comment.
- Reduce the 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 Thailand 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 should be more conservative and withdraw less in bad years. For example, withdrawing 3% in bad years and 4% in good years. This will minimize withdrawal when the market is down.
- Go over your retirement finance 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 powerful tool for DIY investors.
We have been very lucky over the last 7 years, but it could have turned out differently. The stock market could have gone south or our living expenses could have shot up even higher. I’m very happy with my early retirement so far. Pretty soon, I will be retired for 10 years and put the sequence of return risk behind me. Let’s hope the stock market doesn’t crash in the next few years.
In conclusion, 25x expense is just the starting point. It’s pretty safe if you retire at 55 or older. If you want to retire earlier, you should save a bit more or be more flexible. Good luck!
Sign up for a free account at Personal Capital to help manage your investments. I log in almost every day to check on my accounts and cash flow. It’s a great site for DIY investors.
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Image by Zak Suhar
Passive income is the key to early retirement. This year, Joe is investing in commercial real estate with CrowdStreet. They have many projects across the USA so check them out!
Joe also highly recommends Personal Capital for DIY investors. They have many useful tools that will help you reach financial independence.