The Renowned 4% Safe Withdrawal Rule
Friends! Today we’re going to talk about how much money you need to tell your coworkers bye-bye.
Let’s start by unraveling two common retirement myths:
1.) You don’t need to work until your 65, or 59½ or anything like that! There are usually penalties for withdrawing from your tax-advantaged accounts before this age but otherwise, get rid of this arbitrary retirement age requirement.
2.) You don’t need 80% of your current income to live off of when you do retire. If you’re financial advisor tells you that you DO need 80% of your current income then politely tell them to go eat a (insert noun). For example, if you have an annual household income of $100,000 but feel content living on $40,000, you obviously don’t need to live off of 80%.
In The Basic Principles of Achieving Financial Independence, we mention multiple ways that you can replace your j-o-b income. For the sake of simplicity, let’s assume you want to go with the super vanilla strategy of building up an equity heavy portfolio, let’s say 80% stocks, 20% bonds. Statistically, this portfolio will generate somewhere around a 7% annual return via dividend payments and appreciation of the underlying funds. When inflation munches up 3% of the portfolio’s value, you are left with the renowned 4%. You can spend this 4% without ever eating into your principle.
Once you’ve grown your portfolio to the point where a 7% (4% to live off of, 3% to fight inflation) return covers your cost of living, then you’re free!
Yippee, when you do eventually die, you’ll hopefully leave behind a nice chunk of money for your children. If you find that your children are ungrateful assholes, you can make one last positive impact on the world by donating your savings to the Bill and Melinda Gates Foundation.
As an example, if you could cover your cost of living and be happy with $40,000 of income, you would need to grow your investment portfolio to 1 million dollars. (Because 4% of 1,000,000 is 40,000.) While a 4% withdrawal rate should keep you warm and cozy from the point you retire to your end of your time, you may not be as bullish about America’s future. Personally, if I was approaching FI and portfolio income was my only means of replacing my j-o-b income, I’d opt for a more conservative 2 or 3 percent withdrawal rate.
How much do you need to say buh-bye if portfolio income was all that you were relying on?
Setting Up your Freedom Fund Portfolio
To build up your Freedom Fund portfolio, buy Vanguard Index Funds. I’ve tried investing through two different Financial Advisors and it was a bad experience both times. In addition to being sold mutual funds that they probably made a commission off, I’ve never felt like someone cared so little about receiving my business. Business etiquette aside, the actively managed mutual funds that you will likely “be sold” generally underperform the market. Also, the expense ratios/fees are much higher than what you will pay when you buy Vanguard Index funds.
My three favorite Vanguard Funds are:
Vanguard Target Retirement 2060 Fund (Investor Shares)
Fees and expenses: 0.16% , 7.92% return since 2012 inception
The Vanguard Target Retirement 2060 Fund is comprised of four different vanguard index funds, holding approximately 90% of assets in equities (stocks) and 10% in bonds. This fund adjusts risk exposure as you approach your expected retirement date. A common rule of thumb for asset allocation is that you should take 110 – (your age) in order to calculate a respectable stock to bond ratio. I’m 24; 110-24= 86. My stock to bond asset allocation should be about 86% stocks, 14% bonds.
Vanguard Total Stock Market Index Fund (Investor Shares)
Fees and expenses: 0.17%, 9.01% return since 1992 inception
As the name suggests, this fund is 100% invested in the US stock market. Yee-haw!
Vanguard LifeStrategy Moderate Growth Fund (Investor Shares)
Fees and expenses: 0.14%, 7.28% return since 1994 inception
This is another all-index fund that holds 60% of its assets in stocks, and 40% in bonds. For my age, I’d consider this a super risk averse fund. The moderate growth fund is where I park my money, so that I could possibly spend some of it in the next 10 years. I’ll probably only dip into this money if I wanted to buy another house or purchase a rental property.
Once you’ve grown your freedom fund to the size where you can live off of 4% of the portfolio value, you’ve officially reached FI. If you’ve already started to build your freedom fund, sweet, if not, I suppose that’s okay too. Just remember that compound interest is your friend, and as Albert Einstein said, it’s the eighth wonder of the world!