The ‘4 percent rule’, ‘Multiply by 25’ rule and ‘Cash Reserve’ rule.
If you haven’t heard of these rules, don’t worry! I’ll explain.
Multiply by 25
The ‘Multiply by 25’ rule estimates how much money you need to retire worry free.
Here’s how it works: multiply your annual expenses by 25.
For example: if you estimate your annual expenses in retirement will be $80,000, you will need $2 million saved in your investment portfolio.
Notice that this rule doesn’t take into account any other sources of retirement income, like Social Security, pensions, rental properties, etc.?
Since you will likely have some form of guaranteed income if you’re already close to retirement age, you can easily adjust your annual expenses accordingly.
The ‘Multiply by 25’ rule also assumes your portfolio will generate a 4% return per year. It’s estimating that stocks will produce an average return of 6% per year.
If that 6% figure is accurate, and we assume inflation keeps pace at roughly 2% per year, then your return — after inflation — will be about 4 percent.
4 Percent Rule
The 4% rule is you how much money you can safely withdraw once you’re retired, without dipping into your original investment principal.
The 4% rule states that you should withdraw 4% of your investment portfolio in the first year, and continue withdrawing the same amount, adjusted for inflation, each year thereafter.
For example, if you retire with $2 million, then in your first year of retirement, you should withdraw $80,000. The following year you withdraw the same amount, adjusted for inflation. If we assume 2% inflation, you withdraw $81,600.
Depending on how the stock market performed that year, your $81,600 might be worth more or less than 4% of your remaining portfolio. The good news is this rule of thumb has been tested over decades. William Bengen, who pioneered the 4% rule, tested 30-year spending rates against the historical returns of US stock and Treasury bonds.
Some years the markets went up and some years they went down, but the 4% rule takes this into account. As long as you withdraw a steady amount, plus inflation, you shouldn’t run out of money.
Bengen says this rule would have protected your annual income even during 30-year periods that included the Great Depression of the 1930s and Great Stagflation of the 1970s.
Cash Set Aside
If you are working you should have 6 months of expenses set aside in cash, however when you are retired you should have about two years’ worth.
Markets don’t always go up. So if there is a prolonged down period in the market rather than withdrawing income out of your investments, which would further push the portfolio down, you can use the cash reserves. Replenish the cash once markets settle and begin to recover.
It’s not guaranteed. Although, it’s been tested multiple times and it has a high success rate.
If you’re really worried about running out of money in retirement, then always adjust your budget or increase your investments to give you a more conservative estimate. But, which one you choose to follow also depends on your unique situation, risk tolerance, and taxes.
We can help guide you through this process and explain your options.