[Sticky] Target Definition
We define the target you need for financial independence as 25 times your expenses that year.
Is that the right number? As you would imagine with a number that important, there's a lot of disagreement. One thing that everyone agrees on, though, it's better to have too much money in retirement than not enough. We all want at least some of our money to last longer than we do.
The 25x expenses target is another way of saying a 4% per year withdrawal rate from your financial independence nest egg. The 4% annual withdrawal rate was codified in retirement planning by Cooley, Hubbard, and Walz's 1998 paper, http://www.aaii.com/journal/article/retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable?utm_source=sitesearch&utm_medium=clic k">"Retirement Savings: Choosing a Withdrawal Rate That is Sustainable." In this paper, the authors use historical returns data from 1926 to 1995, withdrawal time periods from 15 to 30 years, and five portfolios with asset class distributions from 100% stocks to 100% bonds.
If that historic time period is indicative of the future, 100% of portfolios lasted all time periods with a 3% withdrawal rate and 99.96% of all portfolios lasted all time periods with a 4% withdrawal rate. When the authors assumed inflationary effects, the survival rate of a 50/50 stock/bond portfolio was 95% over 30 years.
There are a couple important caveats to this finding:
- The percent withdrawal rate does not include trading, brokerage or management fees. If your accounts are being managed by a firm charging 1% AUM, your 4% sustainable withdrawal rate is really 3% net of fees.
- The 4% amount is only calculated on the initial withdrawal. For a portfolio of $1,000,000, a 4% withdrawal rate would be $40,000 the first year of financial independence. The authors subsequently withdrew $40,000 per year thereafter, only adjusting for inflation. In BodesWell, since we use inflation-adjusted numbers only, this strategy would result in $40,000 of withdrawal per year. For more about how we handle inflation in BodesWell, please read this post: https://bodeswell.io/community/learn_more/inflation-in-bodeswell/
- The authors acknowledge that the retiree must be flexible with withdrawals in response to the environment and to their particular investment portfolio. In particular, in high inflation or in deflationary environments, the retiree will have to adjust their withdrawals to insure their nest egg lives longer than they do.
In 2010, Wade Pfau reran these numbers and confirmed Cooley's findings (http://wpfau.blogspot.com/2010/10/trinity-study-retirement-withdrawal.htm l"> https://web.archive.org/web/20110708072619/http://wpfau.blogspot.com/2010/10/trinity-study-retirement-withdrawal.html )
For further and pleasurable reading on this, I recommend this Mr. Money Mustache article. It summarizes the two studies mentioned above, points out frequent critiques and then rebuts them.
For a more detailed and thorough review, we highly recommend Todd Tresidder's book "How Much Money Do I Need to Retire" ( https://www.amazon.com/Money-Retire-Minute-Financial-Solutions-ebook/dp/B0093CPJ9S )
Does all this mean that you can rely on historical return rates to ensure your money lasts longer than you do? It does not. It also does not mean that you will absolutely positively will not accumulate more money than you can possibly spend before you shuffle off this mortal coil.
But for now, we'll go with Cooley, Pfau and the research behind 25x annual expenses. Let us know in the comments below if you think we are being too conservative or too liberal.