How much do you need to retire? This is a thorny question that comes up regularly. Many consumers are unsure how much money they will need. The goal of retirement savings is trying to figure out how much of a nest egg you need to build up so that when you start living off your accumulated wealth, you have enough that you will outlive your money.
In order to figure out how much you need to retire, many banks, especially around RRSP season, will try to convince you to save as much as possible. They use scare tactics meant to convince you that you will never retire unless you save as much as possible. However, you don't have to listen to the banks when trying to figure out how much money you need to retire. One simple way to decide for yourself what you’ll truly need to retire is the 4% rule.
What is the 4% Rule?
The 4% rule states that you can withdraw 4% of your investment portfolio in the first year, then adjust for inflation each year after that and not run out of money for 25-30 years. If you are especially careful, your money can last even longer. It's important to note that your portfolio composition does matter. A portfolio of at least 50% bonds at retirement will reduce volatility and increase the odds of this general calculation being reliable .
Another thing to keep in mind is that you can expect some money from the Canada Pension Plan (CPP) and Old Age Security (OAS). While many things can affect the amount you receive each month, including when you start withdrawing from the CPP, as well as OAS clawbacks based on income, a good average for a retired couple is $25,000 per year. Of course, if you have an employer pension you’re even closer to your target retirement income.
Lets say you want to have an income at retirement of $50,000. With a mortgage paid off and children out of the house, this is actually a pretty comfortable amount. As we’ve discussed, CCP and OAS will likely cover $25,000, leaving you with another $25,000 to fund yourself. You can calculate the 4% rule by taking the amount you need, in this case $25,000, and dividing it by 4%. The result, using the 4% rule, is that you would need $625,000 at retirement.
Since the 4% rule also takes into account inflation, the only time you ever take out 4% in the first year. There will be enough room for you to increase your withdrawal by the amount of inflation. So in the first year, you may have withdrawn $25,000. However, in the second year inflation may have increased 2%, so you would now take $25,500 out of your investments. You then continue to adjust your withdrawal amount each year with the rise of inflation.
The Realities of the 4% Rule
Like any money rule, there are limitations to the 4% rule. While the 4% rule is a simple way to calculate for retirement, it may not work out that way in real life. If you retired in early 2008 and watched your portfolio lose 20-40% by the end of the year, you would then need to adjust to a lower withdrawal rate to continue your retirement withdrawals in a way that allows you to outlive your money.
With market volatility, relying entirely on the 4% rule can be risky, especially if you have a large portion of your portfolio in stocks. This is why you should consider having the majority of your portfolio in bonds at retirement, as it might help reduce the odds of such a large loss. You should also consider building in a buffer. Use the 4% rule as a way to provide a general idea of how much you need to save up, but don't assume that it is infallible.