As I mentioned in the last post, the financial goal should target a certain net worth. So the question I get is, “how do I determine the number”? There are many methodologies, but the one I use starts with the 4% rule.
Nowadays, people have warped the 4% rule out of its original context and applied it in methods that it should not be applied. It’s important to understand the original context. The original 4% rule used a mixture of 50% stocks and 50% investment grade bonds using data over a 50 year period in the mid 1900s which includes the Great Depression. Using statistical modeling, it was determined that using a 4% withdrawal rate of your invested assets, there is no 30 year period where you ran out of money.
In practicality, what it means is if your net worth is $1 million in a 50/50 mixture of stocks/bonds, you can withdraw $40K a year, and based on historical data, you will not run out of money over any 30 year period.
This is how the news sometimes report a 30 some year old “retired”. What they do is they drive down their cost of living to say $25K, then apply the 4% rule and get $625K. And retire with $625K. Misapplication of the rule is dangerous. For instance, the 30 year time horizon presumes you retire at 65 years old, and will probably die before 95. Even if you live longer, it isn’t by much and given the 4% rule is a worst case scenario, you are likely fine. However, it does not apply to a 30 year old that has a much longer time horizon with more variability that may happen (ie. inflation, unexpected cost of living increases, needing to support a family member, etc.)
Another misapplication is the type of investments. The original 4% is based on a 50/50 stock/bond mix. It isn’t based on your personal residence or crypto for instance. Applying the rule using net worth from other types of assets or even other allocations was not the original data analysis.
Regardless, it’s a good place to start. Just need to be mindful of the potential pitfalls. That said this is how I would apply the rule.
- You need to estimate how much annual living expenses you’ll need at your expected financial freedom in inflation adjusted dollars.
- If your target retirement age is 65 years old, divide #1 by 0.04 to arrive at your net worth target.
- For every 10 years less in target retirement, reduce the rule by 0.5%. So retiring at 55 years old, use 3.5%. Retiring at 45 years old, use 3%. Retiring at 35 years old, use 2.5%.
So assume you want to retire at 35 years old and expect to spend $100K per year (with expected 2% inflation adjustment per year), you will need $4 million in net worth. However a 65 years old will need just $2.5 million.
No doubt, retiring early is hard. Not only do you need much more to be financially secure than retiring later, you have much less time to invest and compound growth to get there. I agree with Suze Orman when she says all these 30 year old retirees with <$1M is making a big mistake. Now the defense of these 30 year old retirees is that they don’t really intend to stop working/making money, they just want to quit their job and make money their own way (blogging, Youtubing, freelancing, etc.). That is fine, but it really doesn’t make earning an income truly optional. The steps I outlined is to make earning an income truly optional with a high level of financial security where you literally can make no other earned income for the rest of your life.
The other method to make it more conservative is simply to be conservative in estimating your net worth. Because it’s a score, there is a human tendency to see that score increase every time we see the score. Hence there is tendency to inflate the net worth. Inflating it does nothing to change your actual condition. Keep it conservative and do not change the methodology.
