Probably the most jarring transition from your working life to retirement is the switch from a periodic paycheck to the idea of living off investments that need to last, quite literally, a lifetime. Planning for this milestone involves a symphony of countless considerations too complex for one discussion, but there is a rule of thumb that can provide great perspective.
A famous 1998 report called the Trinity Study inspired what is known as the 4 percent rule. (The paper was written by three professors at Trinity University in San Antonio, Texas.) It means that for a typical investment portfolio, an investor can take out 4 percent the first year, then continue to withdraw that same amount — adjusted for inflation — each subsequent year for decades and still have a strong chance of never running out of money.
In fact, when the 4 percent rule is examined over time, the Trinity Study points out that there’s a good chance there will be way more money than the beginning balance in the portfolio at the end of the period and only very rare failures where the money ran out.
The reciprocal of 4 percent is 25, which you can use as a multiplier against annual spending to estimate a portfolio size needed to support your spending. To support a lifestyle of, say, $50,000 a year, investments in the ballpark of $1.25 million are necessary to sustain that level of spending for decades into the future.
There are lots of interesting implications from the rule to think about. Minimum wage of $7.25 and 2,000 hours worked per year indicates annual income of $14,500. Therefore, an investment portfolio of $362,500 could probably produce income like a minimum wage job more or less indefinitely (adjusted for inflation). Consider this milestone on the way to longer-term financial goals.
The 4 percent rule can give you insight on spending decisions, too. Think about eating out for lunch at work. Imagine you could buy a laminated card that was good for today’s equivalent of a $15 lunch each working day, valid at any restaurant, for the rest of your life. How much is that worth? Assuming 262 work days in a year, the 4 percent rule would tell you it’s worth about 262 x $15 x 25 = $98,250. You could set $100,000 aside in an investment account, pay for these lunches out of it for the rest of your life, and probably never run out of lunch money.
But consider converting an expense like that into time. If you net $50,000 after tax from your job, the four percent rule suggests you’d have to work two additional years to prepare to cover a $15-a-day, five-days-a-week lunch habit in retirement. That may or may not seem like a good deal, but at least this way of thinking helps translate something as innocuous as a small daily habit into a tangible estimate of time — the only truly limited resource.
These examples are all hypothetical and are not a substitute for real comprehensive financial planning. Nevertheless, this might be a useful way to frame decisions about work, retirement, spending, and saving. Maybe you love eating out and two years of work is totally worth it, but maybe that fourth streaming subscription nobody watches at your house will get canceled when you convert it to the extra work to sustain it long term.
Have a question or topic you’d like to see covered in this column? Contact the author at ggard@telarrayadvisors.com. Gene Gard is Chief Investment Officer at Telarray, a Memphis-based wealth management firm that helps families navigate investment, tax, estate, and retirement decisions.