Retirement. The 4% rule.

The 4% rule: plan your retirement through an investment fund. Calculate the reimbursement when you’re retired.

If you are close to retirement and you have an investment fund, or if you just want to plan how to manage the available options, this is the post for you. If not, it doesn’t matter, this is useful information that will definitely help you in the future.

First of all I assume that everybody understands the importance of compound interest. Most of your savings must be invested to take advantage of this basic rule of economics.

In this chart you can see the growth of different  capital sums (10k, 30k and 50k) over an investment period of 30 years with an interest rate of 5%, considering Simple Interest or the Compound Interest.

The target of this post is to define the rate of private savings that we can spend periodically at our retirement in a sustainable way. The reimbursement rate is defined as the figure you should withdraw after you are retired.

This rule has some advantages, like the reduced taxes to be paid (as the withdrawals are progressive). Another advantage is linked to the compound interest, while our savings are in the fund these will continue producing benefits. This is a really important issue, considering life expectancy.

The 4% Rule

The last aspect to be considered is fluctuation of the reference markets, because this is a risk to the value of the fund. If we capture a peak rally then perfect, but what if we pick a crisis moment? Here is when the 4% rule comes into the picture.

The theory is as follows. If we assume an average inflation of 2% and the fund gives us a 7% increase, the result is 5%. Then if we withdraw 4% of our saving every year, our saving would never disappear, even in the worst case scenario.

This 4% rule was developed by the Trinity University, (San Antonio, Texas). In the study they analysed the performance of theoretical savings during 30 years, 50% on S&P500 shares and 50% on long-term US bond yields. At the year 1966 (worst case scenario) our saving will still remain durable with a 4% annual withdrawn.

Obviously the distribution between shares and bonds means that the results vary, but In any case it is a good exercise to define our target figure for retirement. The study has been revised several times, but we can summarize that 4% is a reasonable percentage.

Example:

Let’s assume that with 1,200€ per month we have enough to live at the moment of our retirement (current value of money) and that inflation is already discounted at the 4% rule. Maybe it seems like a low figure, but consider that you have already finished your mortgage and the kids are adults now. Maybe we have also another income source, like a public pension, apartment rental income, etc…

If we consider a tax rate of 20%, then, for the whole year we can withdraw

1,200 € x 12/0.8 = 18,000€.

This brings us to the conclusion that we must have the minimum figure of 450,000€ (18,000€/4%) ready at the retirement moment.

Another way to calculate this faster is just by multiplying our annual needs by 25 : 18,000€ x 25 = 450,000€.

Financial Independence Calculator

Now you are ready to start analysing your situation with our Financial Independence Calculator.

Enjoy it!

Note:The content of this article is just a personal opinion. This post does not represent any investment, legal or tax advice. Readyexcel.com and the author if this article are not responsible for the use made by the reader of this information .