4% Rule and the 25% rule of Retirement and Financial Freedom
Have you ever wondered how you can become financially independent or how you can retire early? I have and I still ponder about it. This pondering has lead me to do my research and I was able to find identify various FIRE (Financial Freedom Retire Early) strategies adopted by Millenials to become Financially free and retire young. One such strategy is the 4% Rule of Retirement or also known as the 25x rule of Retirement and Financial Freedom.
I will dive into the subject in the following manner and discuss
- What is the strategy of the 4% rule and 25x rule?
- The origin of the 4% rule and 25x rule.
- How the strategy of 4% rule and 25x rule works
- How this strategy is derived so you can make the right tweaks to it based on your situation.
- The few weaknesses of this strategy. However, if you know how it works, you can easily tweak it to overcome the weakness and personalize it to suit your needs.
What is the 4% rule or the 25x rule of retirement and financial freedom?
It is a rule which focuses on saving 25 times your expected annual expenditures as a corpus fund. Ideally, you begin by tracking down all your actual expenses, future expenses and leave a margin of safety for any unplanned expenses. Once done, use the rule to compute your financial freedom number.
What is the origin of 4% rule or the 25x rule?
This rule was published by William Bengen in his 1994 paper in the journal of Financial planning. The data he used for the study was from the US markets on a hypothetical portfolio of 50% stocks and 50% bonds to find the highest sustainable withdrawal rate for a 30-year retirement. To better understand the ROI, he modeled the returns from 1926 to 1992 in the US.
Although this data may not be applicable for all countries, the concept of this rule is the same for all. Build a corpus and ensure that the withdrawal from returns is the least so that it keeps growing without succumbing to inflation.
How does the 4% rule or the 25x rule of retirement work?
- You find your financial freedom corpus by identifying your future annual expenses (preferably when you retire) and multiplying it by 25.
- Let us say for example if your future monthly expenditure in India is INR 1,00,000, the annual expenditure is INR 12,00,000 (assuming this will also have a margin of safety for any change in market conditions, inflations, and other risks). You will need 25 times of that saved up as your corpus, which is 3,00,00,000 (3 Crores). [12,00,000 x 25 = 300,00,000]
- The next step is to work towards building this corpus. You can build the corpus around different areas of investment. As per the 4% rule, the corpus is divided into 50% into debt (fixed income low-risk avenues) & the other 50% into equity (variable income high-risk avenues). This rule works 96% of the time in 30 years period.
- In your personal case, where you can invest the money will depend on the risk appetite and your age. It may be low risk or high risk but that decision is yours and yours alone.
- Once the corpus is ready, you reach a point of indifference on the “Need to work” and “Want to work”. This is where you decide if you want to retire or if you enjoy your job and want to continue. Once you achieve this number, you are financially independent. You reach a point where you can choose to work or not. Most of us love our jobs and we may never stop working but it is always good to have that cushion if worse comes to worst. That is the beauty of financial freedom.
- If you do retire, the maximum you withdraw is 4% and you leave the balance ROI in your corpus to ensure it grows perpetually.
- Let’s say when you retire your corpus is 300,00,000. You can withdraw 4% of it, which is 12,00,000 per annum. This may be more or less depending on the Fixed Interest Rates in the country you are planning to retire. The balance ROI is reinvested in the portfolio.
- At this point, 12,00,000 per annum is a comfortable amount to be withdrawing to live a comfortable life. Based on where you choose to retire, this may help you live a very comfortable life or a very less comfortable life but you need to plan that way in advance before you actually retire.
- Now if you do decide to retire, it is important how you make your corpus work for you, making your money work for you. So make sure you plan that out too.
How is the 4% rule or the 25x rule derived?
Let me explain in a tabular form how the 25x rule has been derived as a subset of the 4% rule, and how in different situations the 25x multiplier may change depending on the ROI you expect to withdraw.
|Expected Minimum ROI in your Retiring country||8%||6%||4%||2%|
|Max Withdrawal of ROI (50% of above)||4%||3%||2%||1%|
|Multiplier Computation – Divide 100 by the max withdrawal of ROI||100/4||100/3||100/2||100/1|
|The Multiplier – Multiply this with your estimated future annual expenses at retirement||25||33||50||100|
What are the Few weaknesses in the rule and how to overcome them?
Just like any other rule of thumb, the 25x rule and the 4% rule are based on assumptions, which may have some limitations.
- The rules assume you have no other sources of retirement income. In most cases, you may have other sources like pension, rental income, etc. In such cases, you can have a smaller corpus.
- This rule was built on a 30 year retirement period assumption. If you are retiring earlier and young, then it is important to have a higher corpus to ensure the risks of the corpus succumbing to inflation are minimum.
- It assumes the portfolio to be divided equally between low-risk and high-risk investments. There is even a possibility you may run short of funds if you don’t plan well. Consider the risks in avenues you plan to invest in and take the optimum ratio suitable to you.
- The Fixed income interest rates were much higher in the past than they are now. Some countries still have fixed interest returns of up to 8% whereas in some countries we may barely see 1.5 to 2% returns, so research the country you plan to retire in to ensure your money works the best for you. So it is pertinent to plan every possible expense if you are planning to retire such that your corpus will keep growing irrespective of any lifestyle changes.
That is all about the 4% rule. If you have any questions, you can leave an email to [email protected] and we will be happy to answer them. We hope this article was helpful to you. For more such articles, consider subscribing to the newsletter on www.yourrichfreedom.com. Let us reach Your Rich Freedom together!
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