Are You Saving Enough to Retire? A Simple 2-Rule Framework
A friend asked me the other day how much money he and his wife should have in their 401K plans at this point to be on track to retire someday. I answered him with a simple 2-Rule Framework that can be useful for everyone.
The Rule of 72
What It Is: The Rule of 72 is a handy formula for estimating how long it will take for your investment to double, given a fixed annual rate of interest. The formula is:
Years to Double = 72 / Annual Rate of Return
Example: If you have an investment with an annual return of 8%, it would take: 72 / 8 = 9 years for your investment to double.
Application: This rule helps you understand the growth potential of your nest egg over time, and how long-term compounding can work to your advantage. Just remember, this is an approximation and in the real world returns will fluctuate. But if you think long-term, the picture can become a lot clearer with this simple “Rule of 72.”
The 4% Rule
What It Is: The 4% Rule says you can safely withdraw 4% of your retirement portfolio each year, adjusted for inflation, without running out of money over a 30-year retirement period.
Calculation: If you have a $1 million portfolio:
Yearly Withdrawal: $1,000,000 x 0.04 = $40,000
Cautions: This rule has faced a lot of scrutiny in recent years following high markets volatility. Also, a lot depends on your rate of return in the first few years of your 30 year horizon (i.e. if the market tanks in the first few years, things get a bit daunting. But if it rises, you can safely withdraw significantly more).
Here is an illustration from Morningstar with some calculations on a “Safe Withdrawal Rate.” The chart only goes through 1993 (we’ll have updated data momentarily), but as you can see the actual SWR has been much higher than 4% historically.
However, given heightened volatility in recent years, combined with the atrocious returns of bonds (negative) thanks to the fed’s draconian monetary policies, Morningstar lowered their SWR to only 3.7% in 2024—yuck!
100% Stock Portfolio
A lot of investors, with a long-term investment horizon, like to consider a 100% stock portfolio because of the historically higher returns. Here are a couple pros and cons of that strategy.
Pros:
Growth Potential: Stocks historically provide higher long-term returns than bonds or cash equivalents, which could lead to significant wealth accumulation over time.
Inflation Hedge: Stocks often outpace inflation, protecting your purchasing power during retirement.
Cons:
Volatility: Stocks can be highly volatile, especially in the short term, which could mean significant losses right before or during early retirement.
Sequence of Returns Risk: Poor market performance in the years you begin withdrawals can severely impact how long your savings last.
Considerations:
And a couple more things you want to keep in mind.
Age and Time Horizon: Younger investors or those far from retirement might handle more stock volatility, but as retirement nears, balancing with bonds or other assets might be safer.
Risk Tolerance: Your comfort with market swings should dictate how much stock exposure you maintain. If you think you are going to panic sell whenever the market is down, you might consider more bonds and/or cash. But if you can handle the volatility then more stocks will likely pay off handsomely in the long run.
Bottom Line: TLDR
Here are the bottom line consideration to keep in mind when using this simple 2-rule framework to answer the question “am I saving enough to retire?”
Savings Goal: Using the 4% rule, determine how much you need to save based on your desired retirement income. If you want $40,000/year, aim for a $1 million portfolio at retirement.
Growth Expectations: Apply the Rule of 72 to understand how long it might take for your investments to grow at various rates.
Investment Strategy: A 100% stock portfolio isn't for everyone. It offers growth but at the cost of increased volatility risk. Diversification (among stocks and bonds) might be key to sleeping well at night for some people.
Remember, these rules are guidelines. Personal circumstances and market conditions can change the results significantly. Consulting with an investment advisor can help you get on track with a plan that is right for you.