And why money isn’t the most important factor
IMAGINE YOU HAD a crystal ball that could tell you your financial future. A magical orb that knew all your spending and investment returns over the next several decades. With such a device, we could perfectly plan out when you could retire to match your spending needs with your retirement income over time.
Unfortunately, no such object exists. While we might be able to estimate your future spending based on your expected lifestyle in retirement, we have no idea what investment returns you will get nor how long you will live.
This is why the Nobel Laureate William Sharpe called retirement the “nastiest, hardest problem in finance.” If it were easy, there wouldn’t be an entire industry dedicated to helping people navigate this period of their lives.
Despite the difficulty of the problem, there are some simple rules you can use to determine when you can retire. One of the simplest is called The 4% Rule.
The 4% Rule
William Bengen was trying to figure out how much money retirees could withdraw from their portfolios each year without running out of money. In 1994 he published research that would revolutionize the financial planning world.
Bengen found that retirees throughout history could have withdrawn 4% of a 50/50 (stock/bond) portfolio annually for at least 30 years without running out of money. This was true despite the fact that the withdrawal amount grew by 3% each year to keep up with inflation.49
Therefore, if someone had a $1 million investment portfolio, they would have been able to withdraw $40,000 in their first year, $41,200 in their second year, and so forth for at least 30 years before running out of money. In fact, running out of money while using the 4% rule has been historically unlikely. When expert financial planner Michael Kitces did an analysis of the 4% rule going back to 1870, he found that it, “quintupled wealth more often than depleting principal after 30 years.”50
But despite its overwhelming success, the 4% rule seems to be the limit when it comes to annual withdrawal rates. When Bengen tested a 5% withdrawal rate, he found that it was too high to consistently work throughout history. In some periods, the 5% withdrawal rate only gave retirees 20 years of income before running out of money. Since this result wasn’t acceptable, he suggested 4% as the highest safe withdrawal rate going forward, and it stuck.
The beauty of Bengen’s 4% rule was that it provided a simple solution to an otherwise complex problem. Figuring out how much you could spend during your first year of retirement was no longer a stressful decision, but an elementary calculation.
More importantly, the rule could be used to figure out how much you would need to save for retirement in the first place.
Given we know that you can spend 4% of your total retirement savings in your first year, then we know that:
· 4% × Total Savings = Annual Spending
Using a fraction instead of a percentage we get:
· 1/25 × Total Savings = Annual Spending
Multiply both sides by 25 to solve for Total Savings, we get:
· Total Savings = 25 × Annual Spending
To follow the 4% rule, you would need to save 25 times your expected spending in your first year of retirement. When you’ve reached this total amount of savings, you can retire. This is why I used this guideline in chapter 5 when discussing how getting a raise can affect your retirement savings. It was the 4% rule in disguise all along.
Fortunately, you will probably need to save far less than 25 times your annual expenses to meet your retirement needs. Assuming you will get some sort of guaranteed income during retirement (for example from Social Security), then you only need to save 25 times your expected spending above this future income.
For example, if you plan to spend $4,000 a month in retirement and expect to receive $2,000 a month in Social Security benefits, then you only need to save enough to cover the excess $2,000 a month, or $24,000 a year.
We will call this your Annual Excess Spending.
Therefore, the equation to determine how much you need to save is:
· Total Savings = 25 × Annual Excess Spending
Using this rule means that you would need to save $600,000 in order to retire ($24,000 × 25). In your first year of retirement you would withdraw the $24,000. In your second year you would increase your withdrawal amount by 3% to $24,720, and so forth.
Despite the simplicity of Bengen’s 4% rule, it does have its naysayers.
For example, one common argument against is that it was created in a time when yields on bonds and dividend yields on stocks were much higher than they are today. As a result, some financial professionals have suggested that the 4% rule doesn’t hold anymore.
Since yield is just the income you receive from a bond or stock over a given period of time, if yields drop so does your income. So if you paid $1,000 for a bond with a 10% yield, you would receive $100 in income each year from it. However, if bonds are only paying a 1% yield, then the most income you could generate from a $1,000 investment is only $10 a year. The same logic holds for dividend yields on stocks as well.
While yields have fallen over time, Bengen argues that the 4% rule still holds. In an October 2020 episode of the Financial Advisor Success Podcast, he argued that the safe withdrawal rate has likely increased from 4% to 5% because inflation is lower today than it was in the past. As he stated:
“When you have a low inflation environment, your withdrawals are also going up much more slowly. So, there’s an offset to the lower returns that you can’t ignore.”51
If Bengen’s logic holds, then the 4% rule may still be the simplest way to answer the question, “When can you retire?”
However, as much as I like the 4% rule, it assumes that spending for retirees stays constant over time. When we look at the data, it suggests otherwise—spending declines as people get older.
Why Spending Declines in Retirement
When J.P. Morgan Asset Management analyzed the financial behavior of over 600,000 U.S. households, they found that spending was highest among households aged 45–49 and dropped in each successive age group. This was especially true among households in retirement age.
For example, among mass affluent households (those with $1 million to $2 million in investable wealth), they found that average annual spending was $83,919 for those aged 65–69 and $71,144 for those aged 75–79—a 15% decline in spending from the younger age group to the older.52
They came to a similar conclusion when analyzing data from the Consumer Expenditure Survey. Among U.S. households aged 65–74, average annual spending was $44,897, yet for households over 75 it was only $33,740—the older age group were spending 25% less.
Additionally, most of this decrease in spending occurred in the categories of apparel and services, mortgage payments, and transportation. This makes logical sense as older households are more likely to have paid off existing mortgages and less likely to purchase new clothing or vehicles.
More importantly though, this decline in spending also shows up within the same group of households over time as well. It’s not just that today’s 75-year-old households spend less than today’s 65–74-year-old households. Those 75-year-old households also spend less today than they did when they themselves were aged 65–74 as well.
Researchers at the Center for Retirement Research demonstrated this after examining the spending behavior of retired households over time. They found that spending in retirement typically declined by about 1% per year.53
Assuming this estimation is accurate, it suggests that a household spending $40,000 a year in their first year of retirement would spend about $36,000 a year by their 10th year of retirement and only $32,000 a year during their 20th year of retirement.
This is why the 4% rule is conservative when it comes to retirement spending. The rule assumes that your spending will increase by 3% each year, even though empirical evidence suggests that it is more likely to decrease by 1% each year. Of course, this conservatism is what makes the rule more attractive to a typical retiree.
However, as much as I like the simplicity of the 4% rule, some people won’t feel comfortable spending down their assets each year. If this sounds like you, or if you plan on being retired for much more than 30 years, then you may want to consider the Crossover Point Rule.
The Crossover Point Rule
Another way to determine “When can you retire?” is to find the point when your monthly investment income exceeds your monthly expenses.
In the book Your Money or Your Life by Vicki Robin and Joe Dominguez, this is called the Crossover Point.54
It’s called the Crossover Point because this is the point when your monthly income crosses over your monthly expenses to grant you financial freedom. This is important because the Crossover Point Rule can be used as a proxy for financial independence at any age.
For example, if your monthly expenses are $4,000, once your investments can pay you more than $4,000 a month, then you have reached your Crossover Point.
How do you find the amount of money needed to exceed your Crossover Point? We will call this amount your crossover assets.
Let’s start with this formula:
Monthly Investment Income = Crossover Assets × Monthly Investment Return
We know this formula is true because your Investable Assets multiplied by your Monthly Investment Return will be equal to your Monthly Investment Income.
We also know that at your crossover point your monthly investment income is equal to your monthly expenses. Therefore, we can rewrite this formula as:
Monthly Expenses = Crossover Assets × Monthly Investment Return
Dividing both sides by the Monthly Investment Return we can solve for Crossover Assets:
Crossover Assets = Monthly Expenses/Monthly Investment Return
In the example above, your Monthly Expenses were $4,000. Therefore, all you need to do to calculate your Crossover Assets is divide this number by your expected Monthly Investment Return.
So, if you expect your investments to earn you 3% per year, then you can approximate your monthly return by dividing this number by 12. Note that this method is only an approximation. To get the exact percentage, use this formula:
Monthly return = (1 + Annual return)^(1/12) – 1
In this case, 3%/12 = 0.25% (or 0.0025).
If you divide your monthly expenses by this monthly return ($4,000/0.0025), you will get $1.6 million. This is the amount of investable assets you would need to reach your Crossover Point. In other words, $1.6 million earning you 0.25% a month (~3% a year) would generate $4,000 in monthly income.
How does this compare to the 4% rule?
Given that the 4% rule requires 25 times your annual spending in order to retire, this means that you would need $1.2 million (25 x $48,000), which is a bit less than what is required for the Crossover Point ($1.6 million). However, this is only because we assumed a 3% annual return on your assets when using the Crossover Point rule.
If you were able to earn 4% a year on your investments, then both rules would recommend the same amount—$1.2 million.
Nevertheless, the Crossover Point is just another attempt to solve a complex problem (retirement) with simple math. Yet despite the rules, formulas, and guidelines presented thus far, your biggest concern during retirement is unlikely to be money anyways.
The Bigger Retirement Concern
So far in answering the question, “When can you retire?” we have focused on the financial aspects of retirement. However, your finances may be the least of your worries when you finally decide to quit your 9 to 5.
As Ernie Zelinski stated in How to Retire Happy, Wild, and Free:
“Contrary to popular wisdom, many elements—not just having a million or two in the bank—contribute to happiness and satisfaction for today’s retirees. Indeed, physical well-being, mental well-being, and solid social support play bigger roles than financial status for most retirees.”55
Zelinski’s book suggests that it is not a financial crisis you need to worry about in retirement, but an existential one. I have heard similar messages from others who reached financial independence early and hated it.
For example, consider what Kevin O’Leary, a.k.a. Mr. Wonderful from Shark Tank, said about retirement after selling his first company at age 36:
“I retired for three years. I was bored out of my mind. Working is not just about money. People don’t understand this very often until they stop working.
Work defines who you are. It provides a place where you are social with people. It gives you interaction with people all day long in an interesting way. It even helps you live longer and is very, very good for brain health… So when am I retiring? Never. Never.
I don’t know where I’m going after I’m dead, but I’ll be working when I get there too.”56
All jokes aside, O’Leary brings up an important point about the value of work and how much it contributes to someone’s identity. Take that work away and some people may find it difficult to find meaning elsewhere in their lives.
Writer Julian Shapiro summarized this beautifully when discussing how his friends were affected by earning large amounts of money:
“In observing friends who’ve sold startups and made millions: After one year, they’re back to toying with their old side projects. They used their money to buy a nice home and eat well. That’s it. They’re otherwise back to who they were.”57
Do you think Zelinski, O’Leary, or Shapiro are lying? They aren’t. Deciding to retire is far more than just a financial decision, it is a lifestyle decision too. So, in order to know when you can retire, you need to figure out what you will retire to.
How will you spend your time?
What social groups will you interact with?
What will be your ultimate purpose?
Once you have good answers to these questions then you can retire. Otherwise, you may be setting yourself up for a future of disappointment and failure. Because as much as I want you to succeed financially, that won’t matter if you don’t succeed mentally, emotionally, and physically as well.
This is one of the reasons why I am not a big fan of the FIRE (financial independence retire early) movement. Though some people can leave the rat race at 35 and enjoy their lives, others find it much more difficult (and not for financial reasons).
For example, after having a discussion about the FIRE movement online, a man named Terrence (not his real name) reached out to me on Twitter to describe his experience as a FIRE nomad. Terrence had retired two years earlier and was now traveling the world and living out of Airbnbs for one to three months at a time.
Though his lifestyle would be considered glamorous to many, Terrence described his life as a “lonely existence” that ultimately wouldn’t work for most people. He concluded:
“Embracing a nomadic FIRE lifestyle means accepting that you are no longer relevant or important and in some ways now operate in the ether between existence and non-existence.”58
It can be scary stuff. Though Terrence’s experience is not the norm in the FIRE community, it showcases some of the possible downsides of an early retirement.
I share Terrence’s story because it illustrates an important truth. Though money can solve many of your problems, it won’t solve all of your problems. Money is merely a tool to help you get what you want out of life. Unfortunately, figuring out what you want out of life is the hard part.
Now that we have discussed retirement, the biggest savings goal of all, let’s turn our attention to the second part of this book—investing. We begin with why you should even invest in the first place.
49 Bengen W.P., “Determining Withdrawal Rates Using Historical Data,” Journal of Financial Planning 7:4 (1994), 171–182.
50 Kitces, Michael, “Why Most Retirees Never Spend Their Retirement Assets,” Nerd’s Eye View, Kitces.com (July 6, 2016).
51 Bengen, William, Interview with Michael Kitces, Financial Advisor Success Podcast (October 13, 2020).
52 “Spending in Retirement,” J.P. Morgan Asset Management (August 2015).
53 Fisher, Jonathan D., David S. Johnson, Joseph Marchand, Timothy M. Smeeding, and Barbara Boyle Torrey, “The Retirement Consumption Conundrum: Evidence From a Consumption Survey,” Economics Letters 99:3 (2008), 482–485.
54 Robin, Vicki, Joe Dominguez, and Monique Tilford, Your Money or Your Life: 9 Steps to Transforming Your Relationship with Money and Achieving Financial Independence (Harmondsworth: Penguin, 2008).
55 Zelinski, Ernie J., How to Retire Happy, Wild, and Free: Retirement Wisdom That You Won’t (Visions International Publishing: 2004).
56 O’Leary, Kevin, “Kevin O’Leary: Why Early Retirement Doesn’t Work,” YouTube video, 1:11 (March 20, 2019).
57 Shapiro, Julian, “Personal Values,” Julian.com.
58 Maggiulli, Nick, “If You Play With FIRE, Don’t Get Burned,” Of Dollars And Data (March 30, 2021).