A Simple Way to Calculate How Much Money You’ll Need to Retire – The 4% Rule

by on January 12, 2012

There are thousands of programs and retirement calculators that financial advisors use to help you calculate how much money you’ll need to retire. Each program takes a slightly different approach. Some use a lot of computing power to map probabilities of success based on financial scenarios and some use simple formulas to calculate results. However, all of these models have one thing in common – they are only as good as the assumptions they are based on. And, the assumptions have to come from you! So, with that said, you can get a pretty good idea of how much money you’ll need to retire early if you can just make the right assumptions. Below is a simple formula you can use that requires just one assumption – the amount of money you will need the first year of retirement.  Here is some background on the rule, known as the 4% rule, and how to apply it to your situation.

The 4% Rule

The 4% rule is used by many financial advisors to make a simple calculation of how much money you need to save for retirement.  While a very simple rule in and of itself, this formula is based on very complex and detailed scenario analysis.  Statisticians have looked at historical rates of returns, economic scenarios, the probabilities of different financial market movements, inflation, and several other factors.  They then computed all of the different scenarios that could happen to these factors during retirement and assigned probabilities to each scenario.  Then, they made a formula based on all of the The 4% rule - How much money do you need to retirescenarios.  The formula was conceived to determine how much money you can withdraw from your retirement savings each year and not run out of money during your lifetime.  Well, according to all of the analysis, the safe amount for you to withdraw during retirement is 4%.

So, the rule says you can withdraw 4% of your retirement savings during your first year of retirement.  It then goes on to say that each year after that, you can withdraw the same dollar amount adjusted for inflation.  That means that your real withdrawal rate will stay the same each year but that the actual dollars withdrawn can grow to match inflation.  Based on the probabilities, if you stick to the 4% rule, you will have a 90% chance that your money lasts at least 30 years.  However, that assumption actually includes many bad scenarios.  If the scenarios pan out a little better, you actually have a large chance of your money growing faster than you spend it.  For this reason, the rule also says that you have a 75% chance of still having 70% of your assets left after 30 years.  Even more exciting, is that you actually have a 50% chance of having twice as much money in 30 years as you started with.  That’s because there is a good chance that your retirement assets will grow faster than the 4% withdrawal rate.  For example, a diversified portfolio of stocks, bonds and cash over a 30 year period should average an annual return of somewhere between 7-10 percent.

Now that we’ve discussed how this calculation was created and how it works, let’s look at how to put the rule to work.

Using the 4% Rule to Calculate How Much Money You Need to Retire

Since the rule states that you can withdraw four percent of your assets in the first year of retirement, then it stands to reason that you will need to save 25 times as much as your first year’s withdrawal.  That means that if you need $100,000 per year to live during retirement, that you will need to save $2.5 million.  Sounds like a lot, right?!  Well, before you jump to a conclusion, let’s look at some other factors that can help you reach this goal.

First, let’s make sure that you are using the correct figures.  If you are not planning on retiring for another 20 years but think you’ll need $100,000 in today’s money, then you need to take into account inflation.  In twenty years, assuming inflation of 2.5%, $100,000 of today’s money would be $164,000.  Make sure you calculate the money needed based on the time you retire.

Now, let’s look at other income that you may have during retirement.  Let’s say you are expecting to get social security payments each month.  The average monthly benefit for retired people is about $1,200 per month.  That’s almost $15,000 per year.  Subtract the $15,000 from the $100,000 you need to live and you now need just $85,000 per year and need to save $2.125 million.  However, if you’re calculating retirement for a time in the future, you will be able to assume a higher social security payment, as they are adjusted for inflation.  We recommend you look at your annual social security statement to help you estimate the amount of money you can count on from social security.

Also, you may have some other form of payment such as a retirement pension account or life insurance that you have purchased.  Estimate how much you think you’ll get each month and then subtract that from the money you’ll need each year during retirement.  Let’s say you’re expecting to get $2,500 per month from your pension.  That’s another $30,000 to subtract, on top of social security payments.  That means that if you needed $100,000 you would now need only $55,000 per year.  That means you’d need to save $1.375 million.

Don’t forget to take your spouse’s social security and pension into account.  Let’s say your spouse is getting the same benefits as you, that would mean that combined you would be collecting $90,000 per year from combined pensions and social security.  That means that you’d only need to withdraw about $10,000 per year from your retirement savings, and that you’d only have to save about $250,000 to be prepared for retirement.

Finally, you should take into account the amount of time until retirement.  Just like you need to make sure that you use future dollars that include inflation in them, you’ll also get to enjoy the compounding growth of investing from now until the time you reach retirement.  For example, if you determine that you need to save $2 million for retirement but you only have $200,000 saved, you could get discouraged.  However, let’s assume you have 30 years left before retirement.  Without adding anything to your savings, and assuming a 9% annual rate of return, that $200,000 will grow to $2.7 million.  You shouldn’t count on getting a 9% return, and you should keep saving as much as possible, but it is comforting to look at how the growth of your savings can help you reach your goal.

Another example would be someone that is 30 years away from retirement age and that hasn’t saved anything yet.  Let’s say that you determined that you need $1 million to retire.  Seems impossible right? Now, let’s look at how much money you’d have to invest each month to reach $2 million in 30 years, given a 9% rate of return.  You’d have to invest $546 per month for 30 years to reach $1 million.  This may seem like a lot of money, but $546 is really only about the cost of the average car payment that many people pay each month.  Furthermore, as you get older you will probably make more money and will be able to save more quickly.  All of these factors should be considered when computing and planning your retirement goal.

We know we didn’t touch on every possibility here and that you may or may not agree with our assumptions, but we hope this gives you a good understanding of saving for retirement and allows you a quick and easy way to get a ballpark estimate of how much money you’ll need to retire based on the 4% rule.  Please leave us any relevant comments you have below.

{ 1 comment… read it below or add one }

Edog February 16, 2012 at 4:36 pm

I enjoyed the article on the 4% Rule. Having been through my own retirement planning and now have been retired for 6 years; I will review my current financial situation and see how close my plan is to actual. Although I did not use the 4% rule in my planning, I will test it against my first 6 years of retirement and see if holds true.


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