The most popular question in personal finance is this one: How much money do I need to retire?

The answer is simple. You tell me how long you are going to live, and the return of the stock market until you die, and I can tell you exactly how much you need to retire.

Unfortunately, we don’t know how long we are going to live and we don’t know the future returns of the stock market, so we don’t know how much you need for retirement. The best we can do is guess.

The 4% Rule

The other best alternative to figure out how much you need for retirement, is the 4% Rule.

The 4% rule is quite straight forward. It simply states that every year, for the rest of your life, you should be able to withdraw 4% of your money without ever running out.

For example. Let’s assume you have one million dollars. Well, the 4% rule suggests that every year, you should be able to withdraw $40,000, without ever running out.

Now, of course, in investments a lot of things make sense on paper, but when you put a theory to the real life test, it doesn’t always work out that way.

The 4% makes two sensible assumptions, which could work most of the time, but it could go awry some times.

The assumptions are:

• The market grows at 7% or higher
• Inflation is 2% or lower.

If any of these sensible assumptions doesn’t materialize, then our 4% rule goes out of the window.

Multiply your expenses by 25

Another way to calculate the 4% rule is by taking your annual expenses and multiply them by 25.

For example. Let’s say your annual expenses are $40,000. If you multiply $40,000 by 25, the result is one million dollars.

The sequence of returns risk

One of the biggest risks of the 4% rule is called the sequence of returns risk.

We spoke that if the market goes up on average 7%, we should be good, right?

But an average return of 7% means that many years the return will be above 7% and many years it will be below 7%.

If the first few years our returns are below 7%, then there is a high probability of failure and the 4% rule may not work.

The solution? a three year emergency fund

Three year emergency fund

If you have a three year emergency fund, you can very easy withstand three years of negative return and still be good. So we have to modify our formula to:

Annual expenses X 28 (X25 will be our retirement fund and X3 will be emergency fund). A three-year emergency fund should be enough to save us in case we face a down market at the beginning of our retirement.

In our case of $40,000 annual expenses, our new retirement amount is $1,120,000. Out of that amount, one million would be in stocks and $120,000 in cash equivalents.

Re-evaluate every year

Of course, the 4% rule is a rule of thumb, it’s not a precises science. According to to it’s creator, it works 95% of the time.

We should not just follow it blindly and hope it works out fine. Specially the first few years.

Maybe, in addition to building a three year emergency fund, another suggestion could be to go from full time work to part time work, or seasonal work, or consulting work. In short, instead of retiring from one day to the other, you could ease into retirement.

Another suggestion is to have a side hustle that produces money from time to time. For example, my blog has some earnings, and I am planning to continue blogging long after I retire. That money could go right into the market or it can continue building a bigger cash cushion.

Conclusion

Although the 4% rule is not perfect, it’s a nice starting point in a world full of uncertainties.

My take is that if you build a three-year emergency fund and the first five years are positive or neutral, you are on your way to a care-free retirement.

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