Whether you hope for a conventional retirement of leisure or plan to keep doing the work you love for the rest of your life, I think we can all agree that removing the obligation to earn income is a good thing. So let's start with the most important question:
How much do you need before you can make work optional?
We can run calculations and predictive models all day long, but let's keep it easy and throw out a few rules of thumb.
The 4% Rule - you can read about the origin of the 4% Rule here, but in a nutshell it says that a portfolio made of 50% stocks and 50% bonds should last at least 30 years if the withdrawal rate does not exceed 4% (including adjustments for inflation). In practical terms, that means that a person should be able to take $40,000 out of a $1 million retirement nest egg each year for 30 years without running out. If you can get by withdrawing less than 4%, your money should last even longer.
The 25x Rule - this is just the inverse of the 4% Rule: once your nest egg reaches 25 times your annual spending, you can make work optional. The math is straightforward: 4% x 25 = 100%, so you'll have 100% of the money you need when you have 25x your required annual spending. If you have a pretty good handle on your spending, you can quickly calculate a ballpark target for retirement saving.
There's a critical component to both of those rules of thumb. Can you spot it?
The number one driver of retirement readiness (and also the top factor for determining what that retirement looks like): how much you need to spend to be fulfilled.
How much you spend impacts your retirement readiness in two ways. First, it determines how much money you'll need to have saved & invested before financial independence is even possible. And secondly, your spending determines how easy (or not) it will be to get there.
Let's start with the first side of that. How much you need to spend for the quality of life you want directly impacts how much money you need before work becomes optional. For example, if spending $5,000 per month gives you everything you need, you won't have to save nearly as much money as you would if you spent $10,000 per month. That makes sense, right?
Here's the kicker: your spending also determines how easy it is to save that money. Saving & spending have an inverse, push-pull relationship: the more you spend, the less you can save, and vice versa. So one super easy way to get on the right track is to prioritize how much you save.
If you spend 100% of your income, then – I hate to break it to you – you're going to work for the rest of your life. If you can have a great quality of life by spending 90% of your income, on the other hand, that means you can save 10% of your income. Now we're getting somewhere!
And once you get in the habit of regularly saving a portion of your income, it's not that hard to bump it up a little more. If you're already saving 10% of your income, it's not a huge leap to increase that to 11%. And if you can manage 11% for a while, why not go for 12%? (You can see where I'm going with this, right?)
Increasing your savings rate by even a percent or two is perhaps the biggest driver of overall retirement success because it both controls spending and determines how large that nest egg needs to be.
Let's dig into that. The math isn't super hard, but if you want to skip to the punchline just scroll down a few paragraphs.
If you're saving 10% per year and you bump it up to 11%, that's a big win. You're saving more, but, since you're also spending a little less, the target amount for your nest egg also goes down a little bit.
Remember that 25x Rule from last week, which says that you're in the ballpark of retirement readiness when you have 25x your annual spending in savings & investments. And if you save an extra 1%, that means you spend 1% less. If we multiply that extra 1% you didn't spend by 25 according to the 25x Rule, we get (drumroll)... 25%.
What's that mean? In a nutshell, saving an extra 1% of your annual income reduces your nest egg target by the equivalent of 3 months' (25% of a year) worth of work. Increase your savings rate by 4% and shave a whole year of work off your career.
So increasing your savings rate means the target number gets smaller and you get there faster.
That's a powerful concept.
Want to get your own retirement savings reality check? Send me an email to start a conversation.
Thanks,
Timothy Iseler, CFP®
Founder & Lead Advisor
Iseler Financial, LLC | Durham NC | (919) 666-7604
Iseler Financial helps creative professionals remove stress while taking control of their financial lives. We'll help identify current your strengths and weaknesses, clarify and refine your long-term goals, and prioritize decisions to improve your financial well-being now and later. Reach out today to take the first step.
Comments