Retirement planning is the process of making your money last for you after you stop working.
Traditionally, this is around the age of 65 – but you don’t have to wait until that age to retire.
What if you wanted to retire earlier? How would it work? How much money would you need?
As it turns out, by following 4 principles, you can actually retire earlier, much earlier in fact:
To retire early, you need to calculate how much money you would need to live off annually.
You take that figure and multiple it by 25 to figure out how much money you need to save.
By investing your money and taking 4% a year, your money will last throughout retirement.
In this post, I talk about the theory of the 4% rule and how to calculate your portfolio amount.
I also talk about how to calculate your savings rate and what you can invest your money in.
Finally, I talk about how to get started on your journey and where to go for more information.
Principle 1: The 4% Rule
The 4% Rule, or the Rule of 25, comes from a study, known as the Trinity study, conducted back in 1998 into retirement planning.
The goal was to figure out, starting with retirees and their life savings, how long would their money last during retirement, and what percentage would they need to withdraw every year to live off, leaving the rest of their money invested.
They ran through 100s of scenarios: what if you had £500,000 and needed £50,000 to live off each year (10%) or what if you had £1,000,000 and needed £40,000 to live off each year (4%).
After years of research, they came up an answer: a withdrawal rate that had a 95% success rate.
I’m sure you’ve guessed it at this point: 4%.
So what this means is that starting off with a large sum of money, by withdrawing 4% a year to live off and leaving the rest invested, you have a 95% chance of that money lasting throughout all of your retirement.
Pretty cool huh!
Principle 2: Your Portfolio Amount
With this theory in place, the next step is to figure out how much money you’ll need to save.
To do this, take a look at your monthly expenses – how much money do you spend per month?
Not just your essentials (rent/mortgage, utilities, food, etc.) but your non-essential expenses also (eating out, shopping, etc.).
After all, you will want to live comfortably during retirement.
Take that monthly figure, multiply it by 12, then by 25, and you’ll get your portfolio amount.
For example, let’s say you spend roughly £3000 a month: £2000 for your essentials (bills, food, transport, etc.) and £1000 for your non essentials (eating out, shopping, activities, etc).
To calculate your yearly spending, multiply £3000 x 12. That gives you an annual spending of £36,000.
This is how much you need to live comfortably per year. To calculate your portfolio amount, multiply £36,000 by 25 (4% rule). That gives you £900,000. I
In other words, you would need £900,000 invested to be able to withdraw 4% a year (£36,000), which gives you £3000 a month to live comfortably during your retirement.
Principle 3: Invest Your Money
You may be thinking: £900,000! How the heck am I going to save £900,000 any time soon?
Forget early retirement, no wonder people can’t retire before they’re 65- it’ll take me decades to save that much!
That is true – if you think that by saving into a bank account that you’ll be able to retire early you can forget about it.
The other principle of early retirement is investing.
Investing would not only grow your money faster, but it would never run out. That’s because of the magic of returns and compounding.
For example, if your investments grow 10% a year on top of what you’re adding; due to the power of compounding, you will find that you will reach your goal faster than you thought.
Not only that, but if your investments grow 10% and you only withdraw 4% a year, that is how you achieve a 95% success rate of your money not running out.
To find out how to invest your money check out my article on index investing.
Principle 4: Save More Money
The last piece of the puzzle is that your time to retirement doesn’t depend on how much you make.
Believe it or not, it actually depends on how much money you save (and invest).
If someone makes £500,000 a year, but also spends £500,000, well that means that they don’t save or invest anything and therefore they can never retire. They have a savings rate of 0%.
However, if a couple makes £70,000 a year between them: spending half of it (£36,000) and investing half of it (£36,000) then they’re in a great position. They have a savings rate of 50%.
This means that, if their money is invested, they could retire in about 17 years! How do I know this?
Check out my article where I explain how your savings rate relates to retirement.
Most people have a savings rate of 5-10%, which is why it takes them decades to retire.
But if you can increase your savings rate to 50% or above, then congrats, you are almost there!
Summary: What Do I Do Now?
If you take these principles and rearrange them in order of what to do from now, it would be:
- Figure out your portfolio amount by calculating how much you need to live comfortably in retirement. What you spend today may be much higher than your post retirement spending.
- Take a look at your personal finances: what is your savings rate? Are you only saving 5% a month? Try to reduce your expenses so that you can increase your savings rate (ideally 50%+).
- Once you have money saved, start to invest. Add this money to an investment account each month. Do not withdraw from it until your investment account grows to your portfolio goal.
- Once you reach your portfolio amount, congratulations, you can now retire! By withdrawing 4% a year from your investments, your money has a 95% chance of lasting all your retirement.
By following these 4 principles, you will certainly be on your way to a fruitful early retirement!
To find out more about early retirement planning, check out the book: Quit like a Millionaire.
The authors talk about the journey to early retirement and what early retirement is really like.
Are you on the path to early retirement? How is it going? Please share in the comments below.
If you want me to explain anything in further detail, feel free to share in the comments below.
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