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Picking Apart the "25 Rule"

September 23rd, 2008 at 07:01 pm

A couple of people commented on yesterday's post, suggesting the rule of multiplying your desired retirement income by 25 to get the nest egg you need. I understand this argument, that by assuming you get a 4% return on investment, you need 25 times the amount you need.

The problem with it is that I don't intend to die with a $1000000 nest egg - I intend to die as close to broke as possible!

Let's crunch a few more numbers, using my own example. Our monthly expenses (without mortgage) run about $3100 right now. Multiplying that by 12, then 25, I get $930000, just shy of a million. At my current savings rate, I'd need to save for 14.5 years to get there. Using a safe 4% rate of return, this would work fine - 4% of $930000 is $37200 annually, or $3100 a month.

Now let's assume that I want the same $3100 payment every month, but the future value to be zero. Excel tells me that the present value (the amount when I retire) needs to be $459840.82, less than half the amount. I can save that in nine years.

Wouldn't you rather retire five years earlier?

5 Responses to “Picking Apart the "25 Rule"”

  1. merch Says:

    Some clarification on the 25 rule. I am saying that with an 8% return, you can withdraw your salary and have enough for a 4% inflation hit.

    In your example, you are negating inflation and also have no extra in case you have a big down year like this year, and you are assuming you know when you are going to die.

    One other thing, in the later years of your life, chances are that you will actually increase your expenses for medical and housing unless you want to live in a state run nursing home.

    But the 25 is a good goal to strive for.

    The other thing you can do is build up a passive portfolio, like real estate. If you could get a couple properties paid off and earning 2-3k a month, you could live off of that and then sell the properties at the end of your life to pay for health care and the like.

    I still say if you retire with 25x, you have no worries. Just too many monte carlo simulations that could go wrong with the scenario you outline.

  2. debtfreeme Says:

    I used to think the same way you do: I want to leave as little money behind and still have enough to live on until...I die.

    unfortunatly it is not easy to determine the inflation rate we will be facing, guarantee the rates you might earn in interest, your health issues in the future that require more money, or even how the market will bear a 4-8% return for you to be able to withdraw more than 4%.

    But the important thingis that you are planning and talking, more than more than 60% of the rest of this country. And it sounds like your savings is growing quickly. For that you are to congratulated.

  3. disneysteve Says:

    The main flaw in your theory is that you don't know when you will die. What happens if you run short of money at 85 or 90 but live to be 95 or 100? That would suck, wouldn't it?

    The other problem is we all speak of average market returns. What if you had retired 12/31/07 and this was your first year of retirement? Even with modest market exposure of 30-40%, you'd have watched your nest egg shrivel up in the past few months. You need enough of a cushion to get you past down years in your portfolio, or years when inflation ramps up past the 4% you planned for.

  4. kirsten Says:

    disneysteve; I don't know when I'll die, but one thing is certain - I'm not going to live forever. It seems ludicrous to plan to die with my nest egg whole. There has to be a better assumption to make.

    I've looked at various life expectancy tables, and I do all my retirement planning assuming that I'll live to be 94. Although that's well past the length I can expect to live (especially based on a family history of breast cancer), that's my personal best-case decision. Partly it's based on the fact that my grandmother is still living at home, alone, at age 89, and that her mother lived to be 92.

    Rather than worry about market returns varying, I use a pretty standard 4% rate of return for calculations. Although inflation goes up and down, and interest rates go up and down, the *difference* between them is usually pretty close to 4%. In my simplistic calculations, I figure they cancel each other out.

    In addition, I buy corporate bonds, so right now all my investments are earning between 6% and 8%. The volatile market hasn't affected my portfolio, since I haven't had any mature since the problems started.

    For medical care, I'm fortunately Canadian - I've been paying higher income tax my whole life, and medical expenses will be largely paid for. A nursing home will cost more than regular living expenses, but my parents will probably experience that before I retire. I'll be able to amend my plan at that time with the new information I gain from living through the experience.

  5. retire@50 Says:

    My goal is to not to have a huge amount left in my nest egg also when I die. It's hard to guesstimate exactly what you need, but personally I think you make your best guesses and then live with them for a while and see how they work out. If you retire young you have time to adjust and maybe even go back to work, but I think it's better to go ahead and try it if you think you have enough and then adjust later. BTW one of my favorite early retirement books was written by a Canadian. Stop Working, Start Living by Dianne Nahirney

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