This question is so atypical that many people have not even considered that number exists. In Spain, the public pension has been for years the key factor for retirement. Basically, you live with what whatever pension you get. If you get more you probably spend more. If you get less, you make it work. If there is a small gap, your children or relatives would help you out.
This was popular knowledge until recently. Things are now changing.
Ask any student how much they think their public pension will be. I don’t know how the pension fund is going to be managed in Spain. But it’s a fact that we will not have pensions that cover all our expenses or that we will have to work longer to get them.
This fact opens up a whole new reality and the question of how much you need to retire is now enormously important. As it has already in the US for years.
In this post we will talk about the general rule. It is not a rule that can be applied exactly to everyone, but it is a good approximation. In future post we will take this rule and we will clarify it, criticize it, improve it, etc. etc. It is such a key part of financial independence that it will come many times.
So … How much do you need to retire?
You need 25 times your annual expenses. It’s that simple. This is your first approximation of your financial independence number (FI number). Another way to calculate it is to divide your annual expenses by 4%.
In other words, if you spend 10k a year you can retire if you have 250k.
Note that this is cost, not income. That is, you may earn 20k per year but if you only spend 10k, then your number is 250k.
Our objective is that our savings generate enough income to cover our expenses.
If you have a rental property that generates 1.500 per month and you only spend 1.000 you could retire inmediatly. This would be another strategy. The calculation here is based on liquid investments (they can be withdrawn at any moment).
This rule comes from a paper informally called the “Trinity study“. In this research, simulations were carried out with portfolios for long periods of time to see how much you could withdraw each year without running out of money. These are some of the most important considerations of the study:
- Your expenses won’t change in retirement (they are just adjusted for inflation).
- The portfolio (250k in our case) is invested in stocks (following the S&P500 index) and bonds. The study uses different weights of these two components to see what would have worked best.
- You only take 4% (10k) of the 250k the first year and then increase or decrease with inflation.
- You don’t have any income during retirement: no salary, no pension, no inheritance … nothing.
Taking these assumptions, the trinity study concludes that these are the chances of not running out of money:
So if we withdraw a 4% the first year (and rising/reducing with inflation in the following years) is very difficult that we would need any extra money. The probability of dying without money (or owing money) is very low. Moreover, we must bear in mind that this portfolio has been tested during the worst moments in history for the markets. In fact, in most cases the portfolio that would remain for your heirs would be worth more than double the initial amount at the time of retirement.
Many people think that this rule is too conservative and many others think that it’s too risky. In my opinion, it is an academic exercise that provides the basis for the calculation, but each case is different.
The important thing is not to calculate it as precisely as possible, but to delimit the error.
I focus on delimiting the error. Ok, 4% will not work for everyone but how far can my number be? The truth is that with a withdrawal rate of 3% the portfolio would have survived in almost all cases if you have more than 25% in stocks. History certainly does not predict the future, but it gives us a clear idea of how unlikely it is. If something truly catastrophic happens, money would no longer be the most important thing: nuclear war, atypical natural catastrophes, extraterrestrial invasion (?) …
If we use the 3% withdrawal we have to multiply by 33 instead of 25. In our previous example the FI number would be 330k instead of 250k. Then, we would be sure that our portfolio would exist “forever”.