Working out roughly how much money you will need in retirement does not need to be a daunting task. With these simple retirement rules of thumb you can perform a super quick calculation in a matter of minutes.
4 Percent Rule
The 4 percent rule is used as an indicator of how much you can safely withdraw from your investment portfolio when in retirement. The theory is that you can draw down 4 percent in the first year and then increase that amount by inflation every year with little risk of running out of money.
William P. Bengen was the first to devise the rule. Further analysis was done in the Trinity Study where a number of stock/bond allocations were back tested with data from 1925 to 1995 and it was determined 4 percent was a relatively safe withdrawal rate.
Example: If you retire with $800,000 in your portfolio you can safely withdraw $32,000 in the first year. (800,000 x 0.04 = 32,000)
In the second year you would increase the $32,000 by the rate of inflation. Assuming inflation is 3 percent you would draw down $32,960 (32,000 x 1.03 = 32,960)
The major risk to this approach is if there is a long bear market during the early stages of retirement. This is found when using the Monte Carlo Simulation to determine the chance of a portfolio lasting through retirement. The Monte Carlo Simulation uses a computerised mathematical algorithm to generate 1000s of possible market outcomes in order to see how your portfolio would stand up.
25 Times Rule
The 25 times rule is multiplying your desired retirement income by 25. If you wish to have a retirement income of $40,000 then you would need a retirement balance of $1 million (40,000 x 25 =1,000,000)
As you may have noticed the number 25 comes from dividing 100 by 4 (the 4 percent rule) to roughly determine the required portfolio size. This rule being as simple as it is does not factor in any variables such as pension or other forms of income you may have.
Why 4 percent
4 percent is based on a conservative long term investment rate of return of 7 percent minus 3 percent for inflation. Experts have mixed opinions of this figure from it being way too conservative to way too risky.
? percent rule
As with most rules of thumb they can be customised to suit your own circumstances. Personally I plan to aim for around 3.5 percent myself as I am fairly conservative when it comes to unknowns.
If I was after a retirement income of $60,000 drawing down 3.5 percent I would then require a portfolio balance of $1,714,285 (60,000 x (100/3.5) = 1,714,285)
To see if the math works out on the flip side 1,714,285 x 0.035 = 60,000
Are You on the right track?
A simple way to determine if you are on track with your retirement savings is to understand that a well invested portfolio will generally double every 10 years. If you are planning on retiring at age 65 with $1 million you should have $500K at age 55, $250K at 45, $125K at 35… and so on. This is just the compounding effect and does not take into consideration contributions made during the 10 year periods.
Most retirement calculators assume you should be able to comfortable live off of 80 percent of your last year’s earnings. The current suggested retirement income for a couple in Australia to live a comfortable lifestyle is $59,619. This assumes that you own your own home and are relatively healthy.
A comfortable retirement lifestyle enables an older, healthy retiree to be involved in a broad range of leisure and recreational activities. To have a good standard of living through the purchase of such things as; household goods, private health insurance, a reasonable car, good clothes, a range of electronic equipment, and domestic and occasionally international holiday travel. ASFA
I hope these simple retirement rules of thumb give you an easy way to calculate how much you will need in retirement. Perhaps it will give you a little insight into determining if you are on the right track or not. Remember these are only rules of thumb and the results should be treated accordingly.
Let me know how you go with your calculations. Its making me think I need to save a lot more in order to retire comfortably!