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How will I know when I've saved enough to retire?

Mason jar filled with drink at the beach in Bohol in the Philippines.

If you start a financial independence blog and don’t include a post about the 4% rule, did you really start a financial independence blog?

The “4% rule” is one of the most commonly talked about topics within the FIRE community.

This rule of thumb comes from a six-page article published in February 1998 by three professors from Trinity University in San Antonio. For this reason, the 4% rule is also called the Trinity study.

The Trinity study

The authors of the Trinity study were trying to figure out how much money a retiree could withdraw from their portfolio every year without running out of money.

To answer this question, they experimented with the following variables:

  • Annual withdrawal rates ranging from 3% to 12%
    • For example, a 4% withdrawal rate on a $100,000 portfolio would allow the retiree to withdraw $4,000 per year
  • Number of years the portfolio should last, ranging from 15 to 30 years in 5 year increments
    • The authors expected retirees would die after this period 😁
  • Portfolio allocations
    • The allocations they examined included 100% stocks, 75% stocks/25% bonds, 50% stocks/50% bonds, 25% stocks/75% bonds, and 100% bonds.
    • The S&P 500 was used to represent stocks and high-grade corporate bonds were used to represent bonds.

These variables were then used to determine the success rate of the 200[1] possible combinations of portfolios, say, a 100% stocks portfolio with a 4% withdrawal rate over 25 years or a 50% stocks/50% bonds portfolio with a 6% withdrawal rate over 15 years.

A successful portfolio is one which has at least one penny remaining when the retiree dies. 💀

Here’s what the authors found:

  1. Higher withdrawal rates (spending more money) and longer timeframes (needing the money to last longer) decrease a portfolio’s chance of success
  2. Having more than 50% bonds in the portfolio greatly reduces success as the return on bonds is much lower than the return on stocks
  3. Having some bonds in the portfolio (say 25%) increases success as it provides some diversification
  4. And finally, the finding that the FIRE movement picked up on (emphasis mine):
    • If history is any guide for the future, then withdrawal rates of 3% and 4% are extremely unlikely to exhaust any portfolio of stocks and bonds.

That line right there is the source of the 4% rule, the First Commandment of the FIRE movement.

Moses with the Ten Commandments edited to say 'Thou shall talk about the 4% rule as often as possible'

Why is this game-changing?

Put in other words, the 4% rule says that you can withdraw 4% from your portfolio every year until you die and never run out of money.

The corollary to the 4% rule, then, is the 25x rule which tells you how big your portfolio needs to be to make the 4% rule work.

If you want to withdraw $1,000 per year from your portfolio and follow the 4% rule, how big does your portfolio need to be?

The 25x rule comes to the rescue.

25 times $1,000 is $25,000.

4% of $25,000 is $1,000.

Bam. Save up $25,000 and you’re good to withdraw $1,000 per year until you die.

🗒️ Sidenote

1 ÷ .04 = 25, hence the 25x rule.

If you want to follow the 2%, 3%, or x% rule instead just divide 1 by the withdrawal rate to get your multiplier.

1 ÷ .03 = 33.33 so you need 33.33 times your desired withdrawal amount to follow the 3% rule. Given the example above, you'd now need $33,333 instead of $25,000.

The Trinity study is absolutely monumental and the authors deserve credit as being one of the forefathers of the FIRE movement as they provided some key insights that paved the way for later flag-bearers, like Jacob Lund Fisker and Mr. Money Mustache.

🗒️ Sidenote

Wait, if I have $25,000 and I spend $1,000 per year, wouldn't I run out of money in 25 years?

You would if the $25,000 was stuffed under your mattress. However, the returns you make by investing in stocks and bonds helps the stash last longer.

Assuming a 5% annual growth rate, your $25,000 portfolio would grow by $1,250––$25,000 × .05––a year. Subtract your $1,000 withdrawal and your portfolio will be at $25,250. It grew by $250 even with your withdrawal! 🎉

But––there's always a but––economic depressions, recessions, and crashes are all too real. So that 5% gain will be a 10% loss in some years. 😿

The Trinity study used historical data and found that after accounting for all the economic booms and busts, 4% was a safe withdrawal rate.

Mr. Money Mustache, in fact, is probably the one who popularized the 4% rule in his 2012 posts, The Shockingly Simple Math Behind Early Retirement and The 4% Rule.

Mr. Money Mustache says:

Take your annual spending and multiply it by somewhere between 20 and 30. That’s your retirement number.

He then says 25 is his preferred number and so FIRE enthusiasts adopted both the 4% and 25x rules.

So things are looking pretty simple so far.

To figure out when you’ve saved enough for retirement:

  1. Calculate your annual expenses
  2. Multiply that number by 25
  3. Enjoy a daiquiri on the beach

Bad news

Unfortunately, the 4% rule is deeply flawed as Karsten carefully lays out his 50-part (!) series.

Steven Universe. He's happy then he's sad.

Why is the 4% rule flawed?

  1. 30 years was the longest timeframe considered in the Trinity study.
    • Yet if we retire early, say at 35, we have to extend this window out to 60 years.
    • Remember the first finding! Longer timeframes lead to lower chance of success.
  2. Stock valuations today are less “attractive” than in the past.
    • We can divide a company’s stock price by its earnings to get the PE (price-to-earnings) ratio for the stock.
    • If the stock is cheap and earnings are high, the PE ratio will be lower and we’re getting more bang for our buck.
    • Long story short, PE ratios are currently much higher than in the past meaning future returns are likely to be lower.
  3. Dying with 1 penny left was a successful outcome in the Trinity study.
    • Running out of money in year 57 if a 60-year plan is a catastrophic scenario!
    • We’d be 92 if we retired at 35 and probably wouldn’t have the option to work a few more years.
    • We need to add a buffer if we want to leave an inheritance for our kid(s) or charity or if we don’t want to risk running out of money.
  4. The Trinity study doesn’t take investment costs into consideration.
    • Investment costs play a huge role in the success of one’s portfolio.
    • This is why it’s important to use mutual funds (like VTSAX or FSKAX) that have expense ratios below 0.05%.
    • An actively managed portfolio likely charges 1 to 2% in fees which absolutely destroys the chances of early retirement working out.

What now?

So what we do with this Authoritative Rule turned rule of thumb?

Two things:

  1. As Karsten shows, 3.5%, rather than 4%, is safe(r) for an early retiree facing 60+ years of retirement.
    • 3.5% instead of 4% turns the 25x rule into the 28.6x rule.
    • Don’t make the mistake of thinking, “0.5%! What’s the difference?!” The difference is huge.
  2. Get informed.
    • Read my Personal Finance Basics series.
    • Read Karsten’s 50-part series on safe withdrawal rates.
    • Take notes and think critically about the information. Does it make sense? Do you agree? Why or why not?
    • No need to drink from the firehose. Read slowly through the months and years to come.
    • I’ll be continuing to add all sorts of goodies to this site, so check back in.

Our number

My wife and I are currently aiming to have 35 times our annual expenses (a 2.85% withdrawal rate instead of 4%) before declaring ourselves financially independent.

As far as annual expenses go, we’re currently targeting $40,000.

Why 35 times annual expenses and $40,000?

Crunching the data on a 60+ year “retirement” shows that 25 times annual expenses (4%) is highly risky, 28.6 times (3.5%) is on the ball, and 33.33 times (3%) is safe.

I’m a fan of extra buffer and round numbers, so 35 times it is.

We spent about $20K per year from 2018 to 2021, not including rent, and just under $40K with rent included.

This included a trip to Argentina in 2018, to Portland, Vancouver, and Italy in 2019, to Yellowstone and Olympic National Park in 2020, and to Zion, Bryce, and White Sands national parks in 2021.

We’re assuming we’ll own our house outright by the time we’re financially independent so we’ll have no more rent/mortgage payments and would just be on the hook for property taxes.

Throw in healthcare (we currently get it for little through our jobs) and a kid or two (who knows?) and we end up at $40,000.[2]

I don’t include home equity in my calculations and wouldn’t consider myself financially independent if I had a mortgage or other debt.

Summary

This puts our “number” at $1.4 million—35 × $40,000.

So that’s my current answer to “How will I know when I’ve saved enough to retire?”

Your answer will likely be different as it depends on your own annual expenses and risk tolerance as well as your goals, desires, and affinity for round numbers.

Even my own answer will likely change through the years since we see and value things differently as we get older.

The important thing is to raise our sails and get going, pointing the ship in approximately the right direction—we’ll figure out the details on the way.


P.S.: If you’re curious about our progress in our road to financial independence or want to see how we structure our investments, see The Numbers. I update this every month.

Video for this post

If you prefer watching to reading, here’s an easy-to-follow video I made with all this info:

Slides for this post

And here are the slides I used for the video.

Footnotes

  1. 10 withdrawal rates × 4 portfolio duration periods × 5 portfolio allocations = 200 combinations ↩︎

  2. If you think $40,000 is unrealistic for a family of four, read this. ↩︎