You Can Retire on Less Than You Think
Many financial institutions would have us believe that it costs several millions of dollars to retire, or to reach financial freedom, at the age of 65. In reality, you actually need much less. Instead of focusing on a countdown to 65, you should instead be focused on a calculation. In order to maintain your lifestyle without ever running out of money, you really need 25 times your annual spending. If you are responsible with your money and live debt-free, you can live a comfortable life on $20,000 per year in 2015 dollars. This would mean that you can retire with only $500,000. In another post I'll explain how to live on $20,000, but here I'll show you how $500,000 can last.
Understanding the 4% Rule
The reason that I say it takes 25 times your annual spending to retire is because once you reach that level of investment, you are able to withdraw you annual spending each year without much risk of losing money over time. Based on the historical performance of the stock market, you can safely withdraw 4% of your portfolio each year, or put another way, you can withdraw 1/25th of your total balance.
Every year the stock market fluctuates. Some years are great and others are terrible. Sometimes terrible years get grouped together and become known as a financial crisis. But according to the Stern School of Business, on average, the market has returned around 11% over the past 100 years, not adjusting for inflation. Once adjusting for inflation, the stock market has provided real increases of somewhere around 7% - 9% on average over time. Now of course past returns do not predict future returns and it is quite possible that the next 100 years could show lower overall returns, but it has been true for many decades that the average investor could withdraw 4% from an average portfolio each year and still make money. This means that you could also probably withdraw 4% from your portfolio each year and still see the balance last or grow. I'll prove it.
Scenario 1: Withdraw 4% Per Year
Let's pretend the next 86 years are like the last 86 and that the stock market returns will be the same. Wouldn't it be nice to retire today and expect to live for another 86 years?! This scenario will put us at the equivalent of 1928, one year before the start of the Great Depression. You have followed my rules and saved $500,000 and you are retiring, committed to withdrawing 4% each year no matter what. This is what will happen to your money for the next 86 years.
According to the simple 4% rule, the amount that you would withdraw each year would depend on the starting balance. Unfortunately, if you had retired the year before the Great Depression, there would be almost 20 years of withdrawals of less than the $20,000 that you really wanted, and your balance would spend two decades below your original $500,000, but you would never run out of money. This is the magic of the 4% rule.
Scenario 2: Withdraw $20,000 Per Year
Scenario 2 is more realistic and a bit more fun than the real 4% rule. Everything is the same in this example, except that this time instead of withdrawing 4%, you withdraw $20,000 regardless of what is happening in the financial market. This might sound risky, but again I'll show you that it's not. Here is the new financial chart.
This time you get to retire and draw down 20% each year regardless of what happens. If several bad years happened in a row as was the case between 1929 - 1932, your balance would drop from $500,000 down to $199,928, but in the years of positive returns that followed, your overall portfolio would have recovered.
Now I admit that both Scenarios 1 and 2 are probably unrealistic. Again, it is unlikely that the next 100 years will perfectly mirror the last 100, but it is likely that over the long term, investment portfolios will still continue to rise in value. It is also true that neither of these scenarios discuss inflation, but it is still safe to assume that if you could collect $500,000, you would begin to have many more options of how to spend the rest of your life.
If you can practice self-discipline and take advantage of the power of investing, you can probably retire or reach financial freedom in the next 10 - 15 years if you really put your mind to it. $500,000 might not have sounded like a lot before you read this post, but if is really all that stands between you and a work-optional life, that number really takes on a much greater significance.