As FIRE-seekers, all the money we stash away will eventually be put to use to support future living expenses. We put a lot of emphasis on making money and saving it efficiently.
But – at some point you will take a complete 180° U-turn and stop contributing to your investments. Instead of saving, you will begin withdrawing from your savings.
It can be difficult to give up your steady income and quit your job. There is a lot of uncertainty.
What if the stock market crashes?
Absurd! That’s never happened! (wait a minute…)
How much can I take from my investments without depleting my funds?
After all, no one knows how long they’ll actually be in retirement. (a.k.a. no one likes to think about their own death.)
What asset allocation should I choose in retirement?
Depends on how long you’ll be in retirement, which, again, is up in the air. (Probably not cash, though.)
These are all warranted uncertainties and common reasons that may hold you back from pulling the trigger on early retirement.
But I have good new! Many financial studies have analyzed these very situations over numerous different scenarios, including the concerns mentioned above and many more, but one study is particularly important to FIRE…
The Trinity Study
In 1998, three professors from Trinity University published a paper (“Trinity Study”) that studied the effect of withdrawal rates on an invested portfolio’s success (they defined “success” as the final value being positive). They were trying to answer the question:
“How much money can I withdraw from my investments each year without running out of money in the long run?”
They ran simulations of portfolios consisting of different stock-bond mixes over varied retirement periods from 1926 – 2009, and reported the probability of the portfolio’s success at different withdrawal rates. Their updated findings are shown in the table below:
Their findings became popularized as the “4% rule,” because they concluded that it is safe to withdraw 4% of the portfolio’s value each year, regardless of the asset allocation (stock-bond mix). That means that whether your investments lose or gain value in any given year due to market fluctuations, you can withdraw 4% of whatever your total net worth is for that year.
So, if you want to be able to spend $40,000 per year in retirement, you need to save a portfolio valued at $1 million.
- Spend $30,000 – save to $750,000
- Spend $40,000 – save to $1,000,000
- Spend $50,000 – save to $1,250,000
That’s it! It makes the answer to the question “how much should I save?” pretty simple.
Should you really plan on 4%?
There is one MAJOR caveat for early retirees: the Trinity Study only analyzed up to a 30 year retirement period. That seems reasonable, because that’s more or less the typical amount of time people spend in retirement.
Early retirees aren’t typical, though. FIRE-seekers will need to plan for longer periods – probably between 40 and 60 years.
The Trinity Study also uses past performance as a predictor. Just because the market acted a certain way over 80+ years doesn’t mean it will continue to do so in the future.
It also does not consider any income taxes paid at withdrawal. Unless all your retirement accounts are Roth, you will be paying taxes.
Given all these shortcomings, it is probably safer to plan for a lower withdrawal rate than 4%.
Other finance gurus (like the often cited ERN) have suggested somewhere in the 3.25% range. For a 60 year period with 75% stocks, simply reducing your withdrawal rate from 4% to 3.25% increases your chances of success from 85% to 100%. For the same $40,000 yearly spending, you would need a portfolio of $1.23 million.
Another note about savings…
As you can imagine, accumulating a net worth of 25 – 33 times your annual spending (i.e. 3% – 4% of your portfolio value) is no small feat – you must save a majority of your income. It is by far the most important aspect.
The most efficient way to save is to use retirement accounts like a 401(k) and IRA.
Because of their ability to reduce taxes, either at contribution or at withdrawal.
Retirement accounts like these have a hefty penalty for making withdrawals before the defined retirement age: currently 59.5. However, Roth IRA contributions (not investment gains) can be withdrawn from accounts older than 5 years.
Utilizing a “Roth conversion ladder” allows you to make contributions to a traditional account (pay taxes at withdrawal, not at contribution) and then convert that money later to a Roth account (pay taxes at contribution, not at withdrawal). The key to this is to make the conversion during years of reduced income, like when a spouse is in between jobs, or at the beginning of your early retirement.