When you read the blogs and popular press it can be confusing to understand exactly what is required to retire. There is a lot of varying information, so here are some examples of the sort of information you might find. I’ll then summarize my thoughts on each theory.
- $1,000,000 dollars. Often seen as the gold standard for savings, and the aspiration for retirees.
- A net worth of 25X your annual expenses, or 4% draw down per year.
- A net worth of 40X your annual expenses or 2.5% draw down per year.
- Passive income equal or greater than your expenses.
So, lets review each of these, bearing in mind that in today’s world that even if you retire at 65 the money might need to last 30 years.
Social security and, if you are lucky pensions, will help. But if you are looking to retire in your 50’s you don’t have that option yet. So you need to rely solely on your own money.
$1,000,000 net worth.
One million dollars is a nice round number and historically been seen as the place where a family could be seen to be “rich”. Having a net worth of $1,000,000 would put you in the top 12% of the US population. However today I don’t think that much money would be enough for most people to retire without a pension or social security to subsidize. You would need to pull out 5% a year to get $50,000 to live off annually. I would think even for a frugal couple who have paid off their house, $50,000 would be a struggle.
If you pull out $50,000 a year, there is a very good chance that the money would run out well before reaching very old age.
So I don’t think $1,000,000 is enough to retire early. It’s also a bad metric as doesn’t take into account spending habits.
4% Draw Down
One rule of thumb is that if you can pull down 4% of your net worth each year and have enough to cover your expenses then that should be the threshold that you need to retire.
However most studies and Monte Carlo simulations show that this would probably only last 30 years, which would be a risky proposition. This would need your portfolio to grow by at least 4% a year to cover it, plus another couple of percent in order to cover inflation to last longer. Sure later in life there would be social security, but I think relying on a 4% rule of thumb is a bit too risky.
2.5% Draw Down
This is the more conservative version of the above. It relies on having 40X your annual expenses in net worth. so if you want to live off $50,000 a year this means you need a $2,000,000 portfolio. With a 2.5% withdrawal rate then allowing for inflation as long as your portfolio grows by around 4% a year then you won’t run out of money.
Passive Income Equals Expenditure
One of the great things about investing is collecting dividends. If those dividends are equal to your expenditure then you never need to touch your portfolio. You can let it grow through normal market growth.
However doing this is tricky. It requires your portfolio to have a large amount of dividend stocks (which by definition will not grow as fast as growth stocks). This can be done through mutual funds but it does require a little more due diligence than a normal investing strategy.
Our own personal portfolio is a mixture of the last item and the low draw down method. Our dividends will cover about 50% of our expenses and the other 50% comes from about a 1.5% drawdown. We are confident that this will not be risky at all, bearing in mind that pensions will start to kick in in 10 years.
The big revelation for us was that we don’t need to continually grow our portfolio for the rest of our lives, just ensure it doesn’t run out over the next potentially 50 years. We had to ask the question “who are we actually saving for?”
This is something i’ll write about on Friday.