The 4% Rule is Delaying Your Early Retirement
The Four Percent Rule is a commonly used staple in the financial planning industry that states one should be set for retirement once their annual spending needs are 4% of their total retirement nest egg. In other words, the rule suggests that a total portfolio withdrawal rate of 4% (adjusted for inflation each year going forward) should allow for a person to outlive their savings.
For those in the F.I.R.E. (Financial Independence Early Retirement) movement, this rule serves as a benchmark for when early retirement might become a reality. You will find mention of this in some of the larger financial independence followings such that Mr. Money Mustache and the Mad Fientist have developed. The strategy here usually involves aggressive savings mixed with some frugality so that one gets to that 4% mark much earlier in life than the normal retiree.
While I love the idea of aggressive savings mixed with conscious, intentional spending, the 4% Rule is rooted in the speculation that all your savings should go into an investment portfolio. Is that really the best use of your hard earned savings? I will argue no, and that this investment approach is taking years away from your financial freedom.
Here is why.
Let's assume that a particular individual needs $5,000/month ($60k/year) to live in retirement. We'll call this their freedom number. This person has developed a budget that will allow for them to save $1,000/month towards their nest egg. Invested in a balanced investment portfolio, let's assume that their annualized earnings on this savings will be 8%. Considering the most recent 20-year annualized return for a 60/40 portfolio (60% S&P 500, 40% U.S. Bonds) is 6.9% (see chart below), I consider this fairly generous. So, to recap:
Annual spending required: $60,000
Monthly savings: $1,000
Annualized return on investments: 8%
Utilizing the 4% rule on $60k in required living costs, a saver would need a nest egg of $1,500,000 in order to hit their retirement mark. At the savings and earnings rates stated above, a simple time value of money calculation determines that financial independence would occur after 361 months, or right at 30 years.
Now let's compare this to an alternative method of investing.
Keeping the spending needs and savings rates consistent with the scenario above, let's make one tweak and redirect the savings into one of my favorite passive cash flow instruments: real estate. Assuming we are purchasing $80,000 properties with a 25% down payment and 30 year financing, $20k will be needed for each purchase. Once $20k in savings is met and a property is purchased, the added income received will go towards purchasing the next property. In this scenario, we will assume a 10% cash on cash return, which would be $2,000/year or $167/month on the $20k down payment. Utilizing the 1% Rule (see the Real Estate section of this article for a description of the 1% rule), a 10% cash-on-cash return should be relatively easy to hit, even after accounting for all financing and expenses. So, to recap:
Annual spending required: $60,000
Monthly savings: $1,000 (plus $167 each time a property is purchased)
Cash-on-cash return: 10%
At $167/month per property, this individual would need to purchase 30 homes in order to hit their retirement mark, or $5,000/month in free cash flow. In this scenario (and utilizing this calculation), financial independence would occur after 235 months, or right at 20 years.
In case you weren't tracking closely, the real estate investing individual got to financial freedom 10 years sooner, or in two-thirds of the time! That is a huge gain, and proves the power of compounding cash flow versus compounding interest when early financial independence is the primary objective.
A couple items of note:
- This comparison does not account for inflation. Spending needs, property prices and rental income will increase with inflation. For simplicity and standardization, inflation was ignored when doing these comparison.
- Due diligence on purchasing the right properties should allow for cash-on-cash returns above 10%, making the path to retirement even more lucrative and within your control.
- As a side bonus to real estate investing, net rental income received from each investment property should more than double after the properties are paid off. This would increase cash flow substantially as one goes through retirement.
Of course, I am a real estate investing advocate (in case you didn't already know), but do understand that it can be perceived as a scary avenue to pursue. However, I assure you that investing in cash flow positive real estate is not that painful of an undertaking, and the benefits of doing so are undeniable (simply look at the numbers). But like everything in life, taking that first step is definitely the hardest, and I get that. That is why I do my best to help educate on the matter, as it's been proven that the more a person understands about a subject, the less scary (and risky) that subject becomes.
A balanced approach to investing would likely serve most best when planning for retirement, as there are definitely risks to both portfolio investing and real estate investing. I have no benefit to gain by whichever path you take, I just ask that you never shut the door to new ideas and a different approach. Remember that by sticking only to traditional thinking you are limiting yourself to traditional results.