The 4% Rule
One of my favourite facts about money is known as the 4% rule. The idea is that if you only need to withdraw 4% of the value of your portfolio every year, that money should last forever (because the returns on the rest of the money will on average more than make up for the spending). This concept is used by many people in the FIRE (Financial Independence, Retire Early) movement to calculate how much they need for early retirement. I like doing this calculation because it gives me a direct plan towards financial freedom, something that for most people is often shrouded and mystery and associated with stress. The numbers in this post aren’t overly important, everyone is different, you might want to spend more money, your income might be higher or lower than mine, but if you have any space in your budget it can be really useful to figure out what that little bit leftover could become if invested continually over time.
This is not a post about whether the 4% rule really works, there has been work suggesting it should be 3% or 5% or some other such number. I’m going to use the 4% rule because it’s used more commonly than the others.
How much I want to have
You can express the 4% rule as the 25x rule, if you have 25x your annual spending than you should be able to retire at that level of spending. If I want to spend $20,000 a year (which is what I currently believe I will live off before I have dependents) then I will need 25 x $20,000 = $500,000 to support that lifestyle. If I earn on average $60,000 a year (this is a hypothetical number, if you are going to use the calculator yourself, just pick a number a little above what you earn now to account for modest raises that you are likely to receive) and am only spending $20,000, then that leaves me with $40,000 a year left over to invest, you can add to this any returns you get from investments previously made.
How long it will take me to get it
I’ve done the calculation for this by hand before, but it’s a lot easier to use an investment calculator like the one here. If you assume average rate of return of 7%, $40,000 yearly contributions, and no saving to start with, it will take me 9.074 years to have half a million dollars.
Why I do calculations like this
I think that doing calculations like this are useful because they let you understand the impacts of the choices you are making now on the rest of your life. $20,000 a year isn’t an enormous amount of money, but if you want $40,000 a year it will only take 15 years (at that point you have made $400,000 just in investment returns). It’s difficult to make sacrifices for something that you don’t understand, but knowing the effect not spending a lot while working full time now will have on my freedom in a few years’ time is very inspiring to me. It’s important to recognise that while this plan will definitely not happen in the way I have written it (my income will be higher or lower, I may spend more or less money, the market may not provide returns in line with historical averages) it is nice to have a baseline goal and a mechanism for getting there.
