The Three Numbers You Need to Know for DIY Retirement Planning
Last week we discussed the attitude that is required to learn to live below your means without feeling that you are sacrificing. Now let’s apply some numbers to this concept. I’m visualizing your eyes starting to glaze over as we start to discuss math. This is really simple yet important. Hang in there with me. You only need three numbers and the ability to multiply and divide. The numbers you need to know are 4, 25 and 300.
The question everyone has when starting retirement planning is “How much money do I need to save to retire?” When we first started using a financial adviser, he told us that a good rule of thumb is that you will need to be able to replace 80-90% of the income that you had at the time you retire. This is a general rule that is seen everywhere. This is also garbage advice. For starters, when we are young we have no idea how much we’ll be making at “normal” retirement age which could be 40+ years away. This makes it impossible to set any type of reasonable goals or expectations. More importantly is that the 80-90% rule is a generalization over a large population. It makes the assumption that we all spend our money in the same way. Some people save nothing, spending every single penny they earn and even going into further debt. The simple math for these people makes it obvious that they will never be financially independent. They will always rely on an employer or some program (social security, pension plan) to be able to survive. Other people save 50%, 60%, 75% or even more of their pay. For these people, financial independence and the option of early retirement can be had after a working career of 10 years or less as they realize that they only need to provide enough income to cover their relatively low living expenses.
When you are doing your own personal financial planning, you do not need to make any assumptions based on how other people manage their money. You need to take a long look in the mirror and assess how YOU spend your money. You then need to plan for your own specific needs and realize that you are in control of the choices you make in how your money is spent.
The need for a better model leads us back to our three numbers.
First let’s discuss then number 4. There has been research done to determine how much money you could safely withdraw from your investments annually without running out of money. (There is a lot of methodology and many assumptions that went into this research which are both interesting and important to understand. We’ll look at this in detail in the future. For now we’re greatly oversimplifying to begin laying the ground work to allow you to get started today.) It was determined after looking back retrospectively on many years of past market performances that you could safely take 4% of your assets on the year that you retired. You could then continue to draw this amount every year there after, while increasing your withdraws to keep pace with inflation with almost no chance of running out of money. This is known as the 4% rule.
This leads us to the second number that we need to know, which is 25. The rule of 25 simply represents the inverse of the 4% rule. If you can withdraw 4% of your investments safely then you know that the amount of money that you need to retire is 25X your annual expenses. Thus you can calculate your “financial independence” number by figuring out what you spend annually and multiplying it by 25. Say you currently spend $50,000/year, you would need to have $1.25 million dollars to retire today and expect to maintain this lifestyle. Double spending to $100,000/year, you would need $2.5 million to maintain this level of spending. Halve spending to $25,000 and you would need only $625,000.
Using this rule of 25 you can then begin to see the real impact of your spending. For every $100 that you will continue to spend annually in retirement you will need to save $2,500. Since many of our expenses are monthly (utilities, cable, phone, etc.) you can simply multiply 25X12 giving us our third number which is 300. Just as we can multiply our annual expenses by 25, we can multiply monthly expenses by 300 to see how much we would need to save to maintain this spending in retirement. For each $100 you spend each month you will need to save $30,000.
At first this can seem intimidating. These numbers seem huge and difficult to obtain, especially to someone who is used to spending all or most of their paycheck each month. However, with a little thought, this information is also very empowering and motivating when thinking about your spending. For example, even for our household who always has had a savings rate in the 40-50% range we have found ourselves very motivated to find areas to change our spending since learning these rules. One example is cable TV. We had a more basic plan costing about $100/month. My wife talked about getting rid of it for years since we watch little TV anyway. I always felt that it was a minor expense and something we could easily afford. However, looking at this decision with this new perspective, every $100 that we don’t spend per month is $30,000 we don’t have to save for retirement. Since our goal is to be able to retire as soon as possible, this decision became a no brainer. Eliminating our cable bill would allow me to eliminate a full year of work that it would take to save this amount of money, while giving up something with very little value to us. Likewise, my wife was developing a bit of an addiction to Starbucks lattes. This seemingly minor $15/week habit averaged $60/month. Realizing that we would have to save an additional $18,000 to maintain this habit indefinitely led her to begin making her own coffee drinks at home.
Looking at your spending in this way, it is easy to find hundreds or even thousands of dollars of wasteful spending monthly for most of us. Eliminating this spending provides a major double effect. The less you can learn to live on happily, the less you need to save to retire. At the same time, you can apply this money saved immediately toward your investments. This will quickly increase your saving rate and build your investments, shaving years off of your working life if you so choose. The huge gap between your savings and your financial independence number quickly starts to get smaller when attacked from both sides.
Remember that this post is a bit of an oversimplification and we will get in to much more detail on these concepts as we further explain our plans and strategies in the future. For today, commit the numbers 4, 25 and 300 to memory. Begin to track where, when and how much money you spend each month to get an idea on exactly how much you will need to reach your retirement/financial independence number. Every time you look at your expenses, multiply them by 25 or 300 as appropriate to see how much you would need to save to continue to support them in retirement. Then think about whether they are worth this amount of effort. If you follow this simple advice, you will have taken several big bites out of the financial planning “elephant”.
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