How much money do you need to fund your lifestyle forever?
Patrick Venn
Head Of Sales @ TL;DR & Speak On Podcasts | We build brave consumer brands. Our own and yours.
One of the most common goals in personal finance is to have enough money to do whatever you want, whenever you want, with whomever you want.
In other words, become financially free.
I tend to use financial freedom and retirement in this article interchangeably, because to me it’s essentially the same thing. How much money do I need to make work optional?
Since financial freedom is a top goal for many people, I ask employees all the time in our coaching sessions, “Do you know how much money you need to be financially free?”
I have asked +100 employees this exact question and I have got the same answer every single time.
“No clue!”
Everyone wants to be financially free, they just have no idea how much money they need to achieve it.
Is ￡250,000 enough? ￡500,000? ￡1,000,000? ￡10,000,000?
Those are very different numbers. Some are more achievable than others. According to a survey by investment firm?Sanlam Wealthsmiths ?the average UK adult thinks they need ￡355,000 in investments to retire comfortably (or to be financially free).
In reality this equates to an estimated annual income of about ￡14,000. Not a lot of freedom in my eyes! And depending where you live, not enough to cover necessities to survive.
There is a huge gap between expectations and reality.
Therefore I want to take this opportunity to show you how you can quickly calculate your Financial Freedom number.
Now this number is not perfect, your life will ebb and flow over the next 10, 20, 30 years. However, it will give you a good indication of how much you need to be financially free at any point.
It will certainly be more helpful than, “No clue!”
In my opinion, it’s one of the single most important numbers in your financial game plan.
Otherwise you are aiming for an undefined target which is hard to hit ??
The “25x Rule” & The “4% Rule”
The 25x rule is a basic guideline for retirement or financial freedom. The guideline suggests that in order to maintain your current lifestyle when you stop working, you need to save and invest 25x your annual lifestyle costs.
So what does that look like in reality?
For example, let’s say ￡4,000 a month after tax would be sufficient to provide you the lifestyle you want. Some people might find that number small, others might find that number more than enough. It’s extremely personal.
To calculate your financial freedom number, take your desired monthly income and multiple that number by x12 to get your annual lifestyle costs.
￡4,000 (monthly income) x 12 months =?￡48,000 annual lifestyle costs
Once you know your annual lifestyle costs, multiply that number by x25
￡48,000 (annual lifestyle costs) x 25 =?￡1,200,000
In this scenario, you would need ￡1,200,000 to be financially free.
Your next question might be, “Why 25x your annual income”?
Fair point.
There is another rule in personal finance. It’s called the 4% rule, another guideline for retirement.
The 4% rule is a guideline that suggests you can safely withdraw 4% of your investments to live off of for a 30 year period and not run out of money (assuming you leave the rest invested to grow).
Now, let’s go back to our scenario above.
Imagine you built up an investment pot of ￡1,200,000 and you know that you can safely withdraw 4% of that pot to live off per year for the next 30 years.
￡1,200,000 x 4% (or 0.04) =?￡48,000 per year
It’s the exact amount you need to fund your desired lifestyle.
It’s essential the inverse of the 25x rule (i.e. 1/4% = 25…..maths).
The 25x rule calculates how much you need to have in your retirement pot. The 4% rule dictates how much you can safely withdraw from you investments to fund your lifestyle for 30 years.
It’s important to note that these are very simple guidelines, not rules in my eyes!
However, it quickly gives you a rough idea of how much you actually need to be financially free.
The Science Behind The 4% Rule
There is some serious research that has gone into the 4% rule.
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I am going to try and summarise the science without getting too nerdy on you!
It all started in 1994 with William Bengen’s article called?“Determining Withdrawal Rates Using Historical Data”
Told you it was nerdy ??
The entire basis of the study was to answer the question on everyones mind once you stop work.
“How much can I safely withdraw from my investments so that I don’t run out of money?”
He back tested hundreds of retirement scenarios and used a basic 60% stock and 40% bond portfolio to test his theory.
He looked at half a century worth of historical investment data (1929-1976) and concluded that 4% was the optimal safe withdrawal rate, which essentially survived every conceivable economic scenario including some pretty tumultuous ones like The Great Depression.
In 1998, there was another study done nicknamed?“The Trinity Study” ?which was a continuation of Bengen’s hypothesis.
Three professors of finance from Trinity University wanted to test more scenarios including different portfolios (variation of the percentage of stocks and bonds) and extend the time window from 1926 to 1995.
Again their conclusion was definitive.
"If history is any guide for the future, then withdrawal rates of 3% and 4% are extremely unlikely to exhaust any portfolio of stocks and bonds during any of the payout periods between 1929 and 1995.”
The authors of the Trinity Study updated their research in 2009 to see if their theory still worked.
Take a look at the chart below from their updated study. Specifically the “success rates” for withdrawing 4% of your investments based on different time horizons and different portfolios (percentage of stocks and bonds).
Success Rates are defined as, the portfolio was never fully depleted for a 30 year period.
Before you ask, in both studies, the projections were inflation adjusted. In fact, my friends Bryce and Kristy tested if?high inflation destroys the 4% rule . They looked at 3 major periods of historic inflation since 1973 and the maths on the 4% rule still works!
Final Thoughts
The 4% rule, like all things in life, has its fair share of haters. There are two criticisms that I see most often:
Let me kill the first one right away. Although I do think that statement is true, and I agree that nothing in the future is guaranteed based on historical performance. However, I would rather be making investment decisions backed by 100 years of historical data as opposed to discarding it as useless.
And to the second point, the 4% rule assumes that you never make a single pound again for the entire time you are financially free. It assumes you never work again, you never inherit anything, you don’t get a government pension, and you never adjust your financial behaviours. EVER!
Most people I know who are financially free still work in some capacity, it is just that money is no longer the main driver for them.
If there was a major recession, they would most likely adjust their spending behaviour a bit to ride out the short term dip in their portfolio.
Like with all “rules” they are imperfect. The 4% rule is not gospel. It’s simply a quick and easy way to understand the rough amount you need in the future.
One final thing.
When you first calculate your financial freedom number, oftentimes it can seem terrifyingly large.
Almost unattainable.
If that’s you, use the?TOMII investment calculator ?and project how much your investments can be worth by putting away ￡350 a month for the next 35 years based on a 8% annual return (the average return of the US stock market for the past 100 years).
I think you will be pleasantly surprised ;)
???Patrick &?TOMII Tribe
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However, we have had individual people reach out and ask if they can sign up to TOMII and get access to a financial coach.
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2 年Really enjoyed this Patrick Venn. Concise, to the point, simplistic, but profound delivery.
Founder & Director | Problem Solver | Results Focused | Strategic Thinker
2 年Great quick rule of thumb!