I have to give my parents credit for teaching me the importance of saving and investing for retirement, and teaching me the magic of compound interest. But for as long as I can remember, I figured retirement was when you reached age 65. That was just the age I had in my mind, and I think that's pretty common.
Over the years, I have had plenty of clients age 65+ who are still working - not necessarily by choice, but because they have to do it to survive! Social Security is NOT enough to cover an average person's living expenses, so you will need a more comprehensive plan. But assuming you're planning ahead and investing money for retirement, how do you know if you'll have enough?
A couple of years ago I discovered what's called "The 4% Rule" and it really helped me frame my retirement in terms of an achievable goal, in a way other advice I'd ever heard didn't really do. The 4% Rule arises out of the Trinity study and in simple terms, says that you can safely withdraw 4% of your retirement investments, adjusted for inflation, and have virtually no risk of running out of money.
So, to put this in perspective of dollars, if you can acquire $1,000,000 in your retirement portfolio, 4% of the balance is $40,000, and thus you can safely withdraw $40,000 per year to live off of, adjusted for inflation, for the duration of your retirement. Another way to conceptualize the idea is to figure what your annual cost of living is, and multiply it by 25, and that will give you a target retirement balance to shoot for. If I know my expenses are $4,000 per month, that would be $48,000 per year, and so $48,000 x 25 = $1.2 million as a target retirement balance.
The examples above do not factor in expected social security or any other sources of income, but when running projections, you may want to figure those amounts in. For example, if my monthly expenses are $4,000, but I'll have $1,500 per month of social security coming in, the gap will be $2,500 per month that I will want to cover with my retirement funds. $2,500 x 12 = $30,000 per year x 25 = $750,000 as a target retirement balance.
You might be saying something like "Cool, but this is useless for me - how will I ever get so much money saved up for retirement?" That's a valid concern, but one that can be most easily solved with time, consistent investing, and some reasonable assumptions of what the stock market is likely to do based on how it has performed over its existence.
INVESTING ASSUMPTIONS:
1.) Over the long term, the S&P 500 grows at an inflation adjusted rate of approximately 8%. The S&P 500 is an index that tracks the performance of the 500 largest US companies. Moneychimp.com has a very helpful tool that shows the historical returns of the S&P 500 over specified periods of time here: CAGR of the Stock Market: Annualized Returns of the S&P 500.
Investing in an index fund that tracks the S&P 500 is a commonly used method to simplify investing and diversify risk compared to picking individual stocks. For more information on index fund investing and the rationale behind it, I highly recommend J.L Collins' book The Simple Path to Wealth, or just start by listening to his appearance on Episode 20 of the Bigger Pockets Money Podcast where he explains the high points. If you are investing in an index fund that tracks the S&P 500 or the total stock market, it's a reasonably safe assumption that your inflation adjusted returns will be in the neighborhood of 8% over the long term. Also, using the inflation adjusted percentage makes the numbers easier to conceptualize, as you are thinking of the future dollars in terms of today's purchasing power - comparing apples to apples rather than trying to figure out what an inflated dollar of the future means in today's terms.
2. Compound Interest + Time = Exponential Growth
The growth of the stock market is referred to as the Compound Annual Growth Rate (CAGR), but for all intents and purposes, when running mathematical calculations and calculating assumed future values of an investment over the long term, this works the same as using a compound interest rate. For more information on how compound interest works, see my prior blog post How Does Interest Work, and What's a Loan Amortization?
Download the following spreadsheet, which is set up to help run calculations using the concepts discussed above. The highlighted cells can be easily changed to track your birthday (to show the projected balances and safe withdrawal rates at your age into the future), the start date and beginning balance already in your retirement portfolio, as well as recurring retirement contributions, your desired percentage to use for a safe withdrawal rate (go higher than 4% for a more aggressive draw down or lower than 4% for more conservative), and your estimated CAGR (I typically use 8% in all my calculations).
Using the pre-filled details, I am assuming our hypothetical investor just turned 20 years old, and starting their investing journey on July 27, 2022, the day I'm writing this blog post. Using the 8% CAGR, and $500/mo invested, you can see how by age 65, they will have invested a total of $270,000 over the span of 540 months, and through the power of compounding, this has grown exponentially over the 45 year span to $2,637,269.95. Using a 4% safe withdrawal rate, our investor could retire in style with approximately $105k per year in income drawn from the retirement account(s). And this would be in addition to any other sources of income, such as social security or anything else someone might be receiving. But, say they only need $50,000 to pay for all their expenses - they could theoretically retire at age 56, when the portfolio balance is sufficient to support $50k per year withdrawals under the safe withdrawal rate.
This spreadsheet is easily adjustable to account for different scenarios. Even simply adjusting for age - say someone is 40 years old today and has nothing in retirement thus far, but can afford to put away $500/mo. By age 65, they will have invested $150,000 over the span of 300 months, and that investment will have grown to approximately $475,000, permitting withdrawals under the 4% rule of about $19,000 per year. That can be the difference between having to work and not having to work at traditional retirement age.
CONCLUDING THOUGHTS
One thing I think about more since discovering the 4% rule is those structural life expenses, like mortgage, car loan, and other loan debt, and how to keep those payments and my overall costs of living low and try to reduce the expenses over time. Reducing expenses and avoiding "lifestyle creep" (when expenses increase along with increasing income) help free up more money to invest now to take advantage of long-term compound growth, and speeds up the path to retirement by creating and maintaining a more affordable budget target to be covered by the safe withdrawal rate.
There is obviously a ton of nuance and detail that you can dive into when exploring these concepts, including the types of accounts to use to gain maximum tax advantage, but the 4% rule provides a very useful framework to help set retirement goals and plan to be able to comfortably cover your living expenses in your later years.
An excellent and very clear and informative article.