The 4% rule: how to know you are financially ready to retire
One of the most common questions people first learning about financial independence ask is: "When do I know I have enough money to retire?"
This is a great question for several reasons:
Having a goal to aim at is critical. Without the destination in mind, you won't really care if you're making progress, but if you know what you're aiming at, you can see if your steps are paying off. You'll also have more motivation if you know there is a light at the end of the tunnel.
Many are unaware that there is actually an answer to this question. This is because greed and marketing - and Instagram - have us chasing a never-ending amount of increasingly expensive things and experiences. If you just think of money as a way to buy stuff, and there's an infinite amount of things to buy, you might need infinite money to retire "in style".
To really know when you have enough money to quit your job and sip fruity drinks in photogenic locations forever, there are two things to consider. The first comes from knowing yourself, particularly, how much you spend in a year, or want to spend in a year of retirement. To find that figure, you need to track your spending.
Modern technology makes this incredibly easy with apps on your phone like "Spending Tracker" (it's free on iOS and Android and can be set to AED). It takes about 10 seconds after you make a purchase to log it into the app and select which category, such as rent, clothes, mobile phone etc. that the purchase belongs to. Almost every financial expert I've ever listened to recommends this as the first step towards taking charge of your economic life, and for good reason. Without this information, you can't really know how much you spend or what you spend it on. And you can't figure out how much you need per year to live on after you stop working.
There are many debates as to how much of your current annual expenditure you will need to make after retirement. Some experts say 70 per cent of what you spend now, as you'll have more time to do things that save you money like cook at home. Others think you will need more than you currently spend, because you'll have to find ways to entertain yourself to avoid boredom. Only you can really answer that question, but for me, a good estimate is just to say how much you spend currently and leave it at that - it's just easier.
Now that you know the amount you spend per year, multiply that by 25. This number is the amount you need in investible assets like stocks, bonds, or preferably low-cost index funds. "Wait!" you're probably saying right now. "Why 25? Why not 20 or 40?" And the answer, as is so often the case, is maths: 25 is the inverse of 0.04, therefore multiplying your expenditure by 25 is the same as dividing it by 0.04 to get the amount you need for retirement.
In 1998, three finance professors at Trinity University in Texas, US, published a study that showed if you withdraw 4 per cent of your assets per year, you have a 98 per cent chance of your money outliving you over the course of a 30-year retirement. This changes a little depending on the percentage of stocks versus the percentage of bonds you have, but if you have a good asset allocation of around 80 per cent stocks/20 per cent bonds to around 60 per cent stocks/40 per cent bonds, odds are, you are good to go.
This means, if you think you will need $40,000 per year in your golden years, you must have a portfolio of $1 million to retire, if you had no other pensions or sources of income. Those with a pension of $20,000 per year would only need $500,000 in their portfolio to provide them with the other $20,000.
If you already have a portfolio of $1m and feel you can live off $40,000, congratulations. You can quit right now and live a relaxing life away from office politics, alarm clocks, and rush hour commutes. You've made it!