Readers, the following conversation is entirely hypothetical. It hypothetically occurred at a recent (did I mention hypothetical?) social gathering:
“So... how much money, really, does a person need to retire?”
“This is a heavy question, it’s complicated. Are you sure you want the answer?”
“Of course I want the answer! I wouldn’t have asked if I didn’t.”
“Okay. Basically there are three steps. First, you need to know how much you spend per year. And I don’t mean ‘know’ in the ‘I vaguely know, sort of’ sense. I mean knowing it with a great degree of precision.
“In my experience, this question by itself stops about half of all people in their tracks, this alone is too much for them.”
“Well, right now I’m putting one of my kids through college and the other kid is about to start.”
“Great! You’ll still want to know exactly what your expenses are, and then you can simply normalize them for what they would be when you’re done putting your kids through school. Make sense?”
“Okay, the next step is to think about what quantity of capital will produce a sustainable level of income that covers your expenses. You do this by using what I call The Magic 4% Number.”
“Magic four percent? Sounds interesting.”
“Four percent is generally regarded as a safe annual withdrawal rate for a diversified investment portfolio such that you are almost guaranteed to never run out of capital. This just means that 4% is what you can take out of your investments each year to support your retirement and remain highly confident that you’ll never run out of money.”
“So I can take out 4% of my investments every year.”
“Basically yes. So if you think about it, you just have a simple math problem now. You know--or you should know--your expense line each year. You therefore simply calculate what amount of capital, times 0.04, produces that level of income. See? Or in other words, take your expense line, divide by 0.04, and that gives you the amount of capital you will need. Oh, wait: remember a moment ago when I said that about half of people check out the second they find out they need to know their expenses with a great degree of precision? This, here, is where everybody else checks out.”
“I’m not checking out, I really want to know this stuff.”
“Well, just giving you a friendly warning. So, another way to think about this ‘Magic 4% Number’ is this: It means you’ll need total investment capital equal to 25 times your annual expenses in order to have enough money to retire.
“Wait, what? Twenty-five times my annual expenses? Twenty-five times? How’s that work?”
“Yep. Four percent is one twenty-fifth of something. If you can spend four percent of your capital in any given year, your total capital has to be twenty five times your annual expenses.
[Pauses, blank stare] “Oh.”
“A lot of times it helps to use a simple example. So let’s say you have a million dollars in investments, say, in various diversified low fee index funds or whatever. You can therefore spend about 4% per year, or $40,000. Forty grand is one twenty-fifth of one million. By the way, this is where most people politely excuse themselves and go talk about something else, anything else, with anyone else. You’re still here! That’s a sign of courage.”
[Looking around] “Yeah, I guess.”
“Well, the rest of this just boils down to what numbers you choose, and the degree of psychological agency and personal power you’re willing to take. There are usually two types of responses people have here. Most people, once they’re confronted with the idea that they need to save, invest and amass capital that equals 25 times their annual expense line, suddenly start spinning their inner mental hamster wheel. They start disputing the numbers or the math, or they claim they don’t really want to be so preoccupied with money, or whatever. Basically they just give pushback--”
[Interrupts] “I would never do that!”
“Great. Nice to hear it. Perhaps you’re in the latter group then. A small fraction of people at this point have a moment of clarity. They realize that this 25 times (or 4% number) means that they have an enormous responsibility to think clearly and carefully about what they spend their money on. They begin to realize, with genuine clarity, that they can adjust their expenses to a wide range of levels, and doing so has an enormous impact on the amount of retirement capital they will ultimately need.”
[Glancing around] “Mmm hmm.”
“They also start to see things differently. For example: monthly recurring expenses, like a car lease, a mortgage payment, or a big cable TV bill, when looked at through this 25 times/4% lens, suddenly start to look like gigantic wastes of money.”
“Wait, what do you mean?”
“Well, think about the amount of capital it takes to fund, say a $400 a month car lease--I mean, that’s $4,800 a year, so divided by 0.04 or times 25, that works out to $120,000 in required capital just to pay $400 a month. This car lease, which previously seemed like not that big a deal, suddenly becomes more clear: it lays a claim on all of the output of a hundred and twenty grand of capital.”
“Huh. I never thought about it that way.”
“Yeah, a $400 car lease and a $200 cable bill start to look a lot different all of a sudden, right? To say nothing of interest payments on credit card debt and other regular, recurring spending that doesn’t really satisfy any real, genuine needs. All of these things just seem a lot less worth it, particularly when they do nothing but lock you in to working for longer, perhaps many years longer.
[Glancing around again] “Mmmm. Right.”
“What this does is give people some serious clarity on differentiating between needs and wants, on actively choosing their spending level, and not letting it be set passively by their needs for social competition or identity construction. Basically it gives you a real shot at being empowered in this entire domain, on really having a mature conception of what’s really important when it comes to financially protecting your family over the long term.”
[Glancing around, this time more nervously] “Uh huh. Well! I see my friend over there. Thanks for all that! Really interesting.”
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