The 25% retirement rule you need to know!

What is it?

  • An estimate of how much you’ll need to save for retirement.
  • It assumes a withdrawal rate of 4% of your savings in year 1 of retirement.
  • Future withdrawals are indexed with inflation.
  • If you want to live on $50,000 in retirement (assuming self-funded), you multiply $50,000 by 25 to get a savings target of $1.25m.
  • The 4% is a withdrawal rate which is estimated to mitigate the risk of depleting your portfolio.

Why?

  • Trinity Paper 1998 investigated sustainable withdrawal rates in retirement.
  • They used historical returns from US stocks and bonds to estimate the ‘Portfolio Success Rates’ of different portfolios.
  • Portfolio Success Rates represent the percentage of all past payout periods support by the portfolios.
  • Over 30-year payout periods the paper concludes that withdrawal rates of 3% and 4% for stock-dominated portfolios represent exceedingly conservative behaviour and are likely to not deplete the portfolios.
  • For shorter payout periods even higher withdrawal rates may be sustainable.

Rule of thumb?

  • The 25% rule is a handy estimate to give people a retirement savings target.
  • But the original paper highlights the portfolio success rates are not 100%, particularly when adjusting withdrawals for inflation.

What if?

  • Inflation is persistently high. Retirees may forgo consumption now to try and preserve their retirement savings.
  • This may exacerbate an existing bias toward lower consumption due to the fear of running out of money.
  • Further research allowing for additional asset classes and enhancing some of the decision-making rules indicates sustainable withdrawal rates may be in the order of 5% to 6% over a 40-year period.
  • Bequest motivation. Some people may forgo consumption in retirement to leave a bigger inheritance for the kids.

25% Retirement Rule

The 25% Retirement Rule is a handy rule of thumb to help people estimate how much they need to save for retirement. It assumes a retiree withdraws 4% of their savings in the 1st year of retirement with future withdrawals indexed to inflation. For example, if a retiree estimates they need $50,000 per year to live in retirement, you multiply this by 25 for a savings target of $1.25m.

The 4% withdrawal rate is an estimate of a sustainable withdrawal rate that mitigates the risk of your savings running out before you do.

Who came up with the idea?

The idea of a sustainable withdrawal rate of 4% is generally credited to a 1994 paper by Bill Bengen[1] which used historical returns of US Stocks and Treasury notes (a type of government bond).

Further development of the research was delivered in 1998 to estimate the ‘Portfolio Success Rates’ of different portfolios of US Stocks and Treasury Bills[2]. Portfolio Success Rates represent the percentage of past payout periods supported by the different portfolio combinations of stocks and bills.

Over 30-year payout periods the paper concludes that withdrawal rates of 3% and 4% per year for stock-dominated portfolios represent exceedingly conservative behaviour which is unlikely to result in a retiree running out of money.

For shorter payout periods even higher withdrawal rates may be sustainable.

Is it foolproof?

Unfortunately, not! The 1998 paper highlights that inflation adjusted withdrawals mean retirees must accept reduced initial withdrawal rates to mitigate the risk of running out of money.

The impact of inflation on retirees may exacerbate an existing bias for lower consumption in retirement due to the fear of running out of money[3].

This may be an acceptable trade-off for some retirees with a strong desire to leave an inheritance for their children.

However, more recent research including additional asset classes and enhancing some of the decision-making rules in the model indicate sustainable withdrawal rates may be in the order of 5% to 6% over a 40-year period[4].

What does it mean for me?

The 25% retirement rule may be a handy rule of thumb when thinking about the future. Asking how much do I need to retire is like asking how long is a piece of string so any help estimating an answer is worthwhile.

In Australia we are fortunate to have the age pension as a safety net if we do last longer than our money. The possibility of a partial pension entitlement in later years of retirement may allow for higher withdrawals and consumption in the early years of retirement. However, it is difficult to estimate the impact of this over 20- or 30-year time periods.

Financial advice can help provide some context for long-term decisions about how much to spend in retirement. This may help mitigate the fear of running out of money.

Ultimately, running out of money at a ripe old age in Australia may not be the end of the world. Assuming we are healthy, happy and find new purpose in our lives a few years on the full age pension could still provide enough income to lead a fulfilling life.

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Sources:

[1] FPA Journal – The Best of 25 Years: Determining Withdrawal Rates Using Historical Data (financialplanningassociation.org)
[2] 199802retire (aaii.com)
[3] ‘Too frugal’: How super funds are helping retirees spend their money (afr.com)
[4] 08-06_WebsiteArticle.pdf (cornerstonewealthadvisors.com)

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