Do you know how much money you need to retire early? If you don’t, you’re far from alone. In 2017, Bank of America Merill Lynch carried out a survey that showed 81% of Americans didn’t know how much they would need. In 2021, research in the UK showed that 38% of people had no idea how much they would need to have a comfortable retirement. Also in 2021, the insurance company Standard Life released the results of a study into retirement. Their findings included:
- Planners expect to retire earlier and to be able to fund their retirement for longer – yet three-quarters of people say they’ve done little or no thinking about the money they’ll need to live on in retirement
- Those who say they are planning for retirement expect to retire at 66, four years earlier than their non-planner peers
- Planners maintain their money will last for 19 years in retirement, compared to 11 years for non-planners
But for those of us chasing the FIRE goal, we’re not sleepwalking without a plan towards a retirement of destitution, we don’t want to retire at 66, and we certainly don’t want to run out of money after 19 years. We want our money to last forever.
But how much do we need? How much can we withdraw from our investments each year to cover our living costs without running out of money?
The Traditional Advice
A financial advisor might well suggest that you aim for 80% of your pre-retirement salary. The problem is that this rule of thumb is aimed at people retiring in their 60s, and it assumes that your expenses will be almost the same in retirement. That’s despite the fact that you eliminate a lot of costs when you’ve retired, such as work clothes, commuting, and are possibly mortgage-free.
If the traditional advice doled out by experts doesn’t apply, what then?
What we need is for some super-smart geeks (and I mean that in the nicest possible way) to crunch the numbers for us. Luckily, they did.
Enter the Holy Trinity
In 1998, three professors of finance at Trinity University in San Antonio, Texas, released a paper called Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable. Since that doesn’t exactly roll off the tongue, and because the professors worked at Trinity University, the study became known informally as the Trinity Study.
The professors wanted to determine what percentage you could safely withdraw from your portfolio year after year without running out of money over various timeframes, up to a 30-year period.
Withdrawing money from your portfolio is a delicate balancing act: withdraw too much and you’ll run out of money. Withdraw less than you safely could have and you’ll have a lower standard of living than you could have had. That’s money you could have spent on friends and family, travelling, hobbies, travel, or whatever else you fancied. Some people want to spend as much of their money as possible without running out, and others want to cover their living expenses while also leaving behind a decent-sized chunk of money for loved ones once they’re gone. Some people are very risk-averse, and some people are more aggressive. With all these opposing factors in play, there’s no one-size-fits-all approach.
The professors used real stock market data from the S&P 500 index between 1926 to 1995 to represent stocks and long-term corporate bonds (essentially loans to big companies) to represent bonds. Their study examined what happened to portfolios based on:
- Annual withdrawal rates between 3% to 12% of your initial portfolio value
- Periods of 15 years, 20 years, 25 years, and 30 years starting from 1926, then 1927, then 1928 and so on
- The portfolio allocations examined were: 100% stocks; 75% stocks/25% bonds; 50% stocks/50% bonds; 25% stocks/75% bonds; 100% bonds
- Success was defined as the percentage of periods where the portfolio ended with more than $0
- Inflation was factored in. If you started off withdrawing £30,000 a year, that might give you a comfortable lifestyle. If you were still withdrawing £30,000 30 or 40 years later, your money wouldn’t stretch very far due to the price of goods and services having increased over time. Over the long-term, stocks typically return around 9% and inflation is, on average, 2-3%. This growth that exceeds inflation is one reason that you can increase the amount of money you withdraw from your portfolio over time
The table below shows the success rates of different portfolios:
These numbers tell you, as someone pursuing financial independence, a few important things:
- You need your portfolio to contain at least 50% stocks
- If your portfolio comprises more than 25% bonds, your chances of running out of money increase in tandem with the more bonds you have
- For a portfolio to last 30 years (and beyond), a withdrawal rate of 3% is about as bulletproof as you’ll get as long as you have at least 25% stocks. If you have at least 50% stocks, 4% is almost certain to lead to you not running out of money
Would You Have Run Out of Money?
The professors wanted to answer the questions, “Is my portfolio likely to last as long as I do?” and “What is the likely value of my portfolio after making all of those annual withdrawals during my retirement years?”
The factors that influenced how much money was left in a portfolio were:
- The length of the payout period
- Portfolio composition (the mix of stocks and bonds)
- The withdrawal rate
The professors called the amount of money left in the portfolio at the end of the payout period the terminal value. They avoided portfolios comprising 100% stocks and 100% bonds, and they looked at payout periods of between 15 and 30 years.
Let’s see what they found:
- The higher the withdrawal rate, the more chance of running out of money (unsurprisingly)
- On average, the portfolio ended up with more money in it, despite years of withdrawals
- The success or failure of a portfolio depended on how the stock market performed during any given period. If you were withdrawing money at 7% while the stock market was tanking, your money would disappear faster than snow off a dyke
- For portfolios heavy in stocks, the amount of money left generally increased over time (due to compounding) but there was also more chance of ending up with no money
- The professors noted that “Investors with longer planning horizons potentially will have larger terminal values, but without mid-course reductions in the withdrawal rate, in some cases, they will experience higher frequencies of portfolio failure. And, as the percentage of bonds increases, the median terminal value decreases, but the minimum terminal value increases, and the frequency of zeros is reduced”. In plain English, if you’re looking at the long-term, as we FIRE people are, then you will hopefully have a portfolio that grows over time, not shrinks. But to ensure that happens, you have to be flexible with your withdrawal rate in response to how the stock market is performing. If it tanks, you need to withdraw less money from your portfolio in order to protect it. The more bonds you have, the less money you’re likely to have compared to stocks as time goes on, but you’re also less likely to run out of money completely
The Professors’ Conclusions
So, after crunching all these numbers, what did the professors conclude?
- The appropriate annual withdrawal rate depends on the mix of stocks and bonds in the portfolio, the length of time the portfolio needs to last, individual tolerance for risk, and whether someone wants to spend more money earlier in retirement or later (for example, spending more in the earlier years while health is better)
- Early retirees should plan on lower withdrawal rates (3-4%)
- Having bonds in the portfolio increases the success rate for low to mid-level withdrawal rates. However, stocks provide upside potential and facilitate higher sustainable withdrawal rates (due to outpacing inflation and continuing the growth of the portfolio). Bonds increase certainty but at the expense of potentially withdrawing more money. Most retirees would likely benefit from a portfolio containing at least 50% in stocks
- Being able to withdraw more money over time in order to account for inflation means you must withdraw from the initial portfolio at a “substantially reduced” rate
- For stock-dominated portfolios, withdrawal rates of 3% and 4% represent exceedingly conservative behaviour. These rates are likely to allow your portfolio to grow over time despite you withdrawing money from it to pay for your expenses
- For short payout periods (15 years or less), withdrawal rates of 8% or 9% from stock-dominated portfolios appear to be sustainable. For those of us pursuing FIRE, we’re hoping for retirements of much longer than 15 years!
The 2009 Update
In 2011, the professors released an updated study that used data covering January 1926 to December 2009.
They concluded that if you want to include annual inflation adjustments then an initial withdrawal rate should be in the 4-5% range, with a portfolio containing 50% or more in stocks.
They also stated that changes in withdrawal rates or amounts can be made in response to unexpected changes in financial market conditions. In other words, if the stock market tanks then you cut back on your spending to protect your portfolio, and then when it recovers you can withdraw (spend) more again.
Some Important Assumptions
The Trinity Study aimed to provide an SWR for retirees in the traditional sense of the word: people retiring at, say, 65. The study aimed to show how much you could safely withdraw from your portfolio without depleting it before death. As such, it made a few assumptions:
- Once someone was retired, they were retired. End of. They didn’t earn any more money ever again.
- Other income wasn’t considered. Here in the UK, we have other sources of income that need to be factored in: the state pension, a workplace pension, or a self-invested personal pension (SIPP), for example. These can’t be accessed until a certain age, but if you have them, in time they’ll bolster your income. As long as your portfolio bridges that gap from retirement until they’re accessible, it’s likely that the extra income you receive will ensure your portfolio will never be depleted.
- The withdrawal rate stayed the same throughout the period examined. In other words, you would withdraw, say, 4% in good times and bad. In reality, being flexible is a must. When the stock market is booming and your portfolio is growing, you’re golden. But if the market drops sharply, you can’t blindly keep withdrawing at the same rate; you need to make sensible adjustments and cut back. This could mean eating out less or going on fewer holidays (or none) until the market picks up again.
These assumptions are good news for us. As long as we remain flexible in our spending, have the option to earn more money after “retiring” (even if it’s not big bucks), and have some kind of extra income in the future, then we’ll be in a better position than those covered by the Trinity Study. On that basis, an SWR of 3-4% is actually a worst-case scenario.
The 4% Rule
These studies, along with an earlier one by Bill Bengen, a financial adviser who created the 4% rule in 1994, give you a good idea of how much your safe withdrawal rate (SWR) should be.
The 4% rule has been much debated over the years. It’s been pulled apart, criticised, expanded to use more current data, and so on. To cut through all the noise and confusion I would say this: treat 4% as a rule of thumb, not a rule. It’s a guideline, not a guarantee.
If you want as close to a guarantee as you’re going to get and still be able to withdraw a reasonable amount of money from your portfolio, use an SWR below 4%, and have a portfolio comprising 75% stocks and 25% bonds. Having your stocks invested in index funds means that the fees will be low enough not to wipe out your portfolio. If you’re aiming to live off of 4% of your portfolio each year, then actively managed funds that charge 1-2% will not leave you enough to live off.
Calculating Your FIRE Number
Now we know what our SWR is (4%) then you can calculate your FIRE number.
4% is the inverse of 25. For example:
You have a portfolio worth £500,000. An SWR of 4% would give you 0.04*500,000 = £20,000.
You can also calculate this the other way. You’ve decided that £20,000 is enough for you to live off each year. 20,000*25 = £500,000.
To calculate your FIRE number, the easiest way is to multiply your annual spending by 25.
If you’d like to play with the numbers, there are a few good online calculators:
https://www.playingwithfire.co/retirementcalculator
https://www.firecalc.com/index.php
Time to get number crunching and find out how much you need!
