Like anything, saving for retirement has its rules of thumb (or would it be rule of thumbs?). These guidelines will help you create the greatest probability of funding your retirement without running out of money.
The two major principles; the ‘Multiply by 25 rule’ and the ‘4% rule’ are often mistaken with each other, resulting in confusion. Both of these guidelines are important, but for completely different reasons – one is meant for saving for retirement and supposed to be started at a younger age. The other rule is meant for sustainably funding your retirement and is a way to live after you enter retirement.
The Multiply by 25 Rule
This is a rule that’s important to know long before you retire, and it simply states: multiply your desired post-retirement income by 25 to find out how much you should save for retirement.
A bit of simple math tells us if you want to take out $50,000 dollars per year from your investments during retirement, you’ll need about 1,250,000 dollars in the bank.
The 4% Rule
The 4% rule is more important for those entering retirement, when your money is saved and you’re more concerned about how much money you can sustainably withdraw from your account. According to this rule, you can withdraw 4% of the total amount in your savings (your nest egg) each year of your retirement.
So, if we go back to the example above, a bit of math tells us you should withdraw $40,000 dollars your first year of retirement, because 4% of $1,000,000 is $40,000. The second year you should take out the same amount, accounting for inflation (estimating 3% inflation would be $40,000 x 1.03 = $41,200). Repeat this cycle every year, and according to the 4% rule, you will have the greatest probability of fully funding your retirement.
Remember, you only need to calculate that 4% once on your initial nest egg. After that, just adjust for inflation.
The 4% Rate of Return
Both these rules are based on a 4% rate of return, which is why they’re so easy to get confused. That’s because experts expect a 7% rate of return from the stock market for decades to come, but also expect inflation to continue right around 3%. So if you go seven steps forward and three steps back each year, you gain four steps, or, in this case, 4% each year for your ‘true’ return on investment.
Adjusting for Inflation and Other Details
Of course rules of thumb are just general guidelines. Some argue these rules are too optimistic, and the more cautious opt for the ‘3% rule’, and the ‘multiplying by 33 rule’. There’s no exact science to saving for retirement, because in the end it’s up to you (hopefully with a little guidance from a trusted advisor), and the amount you believe you’ll need to save and spend for retirement.
Now, for the elephant in the room – inflation. Nobody likes it, but in the real world of retirement planning, you need to account for inflation. So, to make sure inflation doesn’t jump out and scare you a year away from your retirement, add it into your plans now with the equations below:
- 10 yrs from retirement – multiply by 1.24
- 15 yrs from retirement – multiply by 1.40
- 20 yrs from retirement – multiply by 2.085
- 25 yrs from retirement – multiply by 2.34
*Based on 2% inflation rate
Let’s go back up to the example above: you want 50,000 of today’s dollars per year for your retirement. But, retirement 15 years away, so $50,000 won’t buy as much. So, 50,000 x 1.8 = $90,000. That means if you want $50,000 of today’s purchasing power each year of retirement, you need to save for $90,000. Plug $90,000 into the ‘multiply by 25 rule’ and you get $2,250,000.
Proper Planning and Investment with Bayview Financial
Like any glance into the future, this offers no guarantees. Any broker, or financial planner that offers guarantees is selling you a dream they can’t back up. Don’t trust guarantees. At Bayview Financial, we don’t claim to have perfect knowledge of the future, but with proper planning and investing we can help you work towards a comfortable retirement.