The best pieces of financial advice are the ones people can remember. Charts and lengthy equations have their place in the investment world, but I’m a fan of memorable “rules of thumb” that are easy to understand and even easier to apply to your saving strategy.
Enter two of my favorites: The 1000-Bucks-a-Month Rule and the 4% Rule.
These rules of thumb can serve as useful guideposts as you travel the road towards retirement.
I want to focus on the 1,000-Bucks-a-Month Rule. But, before we dive in, let’s distinguish this rule from its cousin, the 4% Rule.
In the most general terms (we’ll get into the “how” in a minute), the 1,000-Bucks-a-Month Rule works like this: For every $1,000 per month you want to have at your disposal in retirement, you need to have $240,000 saved. The 1000-Bucks-a-Month Rule is a great way to visualize how much you need to accumulate in your nest egg to comfortably meet your spending needs. Generally, though, this rule can still be used during retirement so long as you don’t withdraw more each year for inflation.
It’s imperative to understand that this “rule” is a rule of thumb. The rule does not work linearly in any given year, and it doesn’t work the same at every age. It’s geared towards folks who are retiring at “normal” retirement age – between 62 and 65. We’ll talk about why in just a bit.
The 4% Rule, on the other hand, is a handy analytical tool for use once you begin taking withdrawals from your various investments. It states that a retiree should comfortably withdraw 4% of their initial retirement assets per year, and increase that amount annually to account for inflation, assuming a 50% to 75% portfolio allocation to stocks.
More on the 1,000-Bucks-a-Month Rule.
Be sure you understand these two critical components of the rule. (These are the “why” we mentioned earlier.)
Based on my 1,000-Bucks-a-Month Rule, “normal” retirement age retirees (remember, between 62 and 65) can plan on a 5% withdrawal rate from their investments. However, younger retirees in their 50s should plan on withdrawing a lower number each year, typically 4% or less. This is because retiring in your 50s leaves too long a time horizon to start withdrawing 5%. It’s just too early.
Taking a closer look, let’s see how $240,000 in the bank equals $1,000 a month:
$240,000 x 5 percent (withdrawal rate) = $12,000
$12,000 divided by 12 months = $1,000 a month
The 5% withdrawal rate works well in years that the market and interest rates are in a normal historical range. But, you must be willing to adjust your withdrawal rate if market forces work against you in any given year. You may need to take less in those years. You may need to be flexible enough to adapt to what’s happening in our economic environment. Sure, the flip side is that you may be able to take a little extra in the good years. Still, it’s critical to understand that you might need to take less in the years that aren’t as good.
So how long will your nest egg last if you adhere to the 5% rule?
Even if all your retirement savings are in cash and yielding zero percent per year, the funds will help support you for 20 years. A level 5% withdrawal per year x 20 years = 100%. All of your funds may be gone, but it took two decades. Not too shabby.
However, it could be better. What if you have 30 or 40 years in retirement? What if you are thinking about leaving something to your children? If you have a portfolio yield of 3% to 4% (dividends and interest only) and the portfolio experiences even the slightest bit of growth/appreciation, then a 3% to 4% yield plus 1%, 2%, or 3% in growth over time suggests that you can take out 5% over an even more extended period of time.
How do you get that kind of yield and growth? Enter income investing, which is a strategy to generate consistent cash flow from your liquid investments. This income comes from three places: dividends, interest, and distributions. If your cash flow number is already close to 4% from your dividends and interest only, then you’re already near the 5% number we’re looking for. This significantly increases the chance that your money will support a lifetime of 5% annual withdrawals.
This easy-to-follow bit of wisdom can help you remember that you are saving money so that it can one day replace the income stream you will lose when you stop working. Just keep in mind the difference between the 1000-Bucks-a-Month Rule and the 4% Rule. And, as you plan for your retirement, implement the 1000-Bucks-a-Month Rule to see just how much income you’ll need to supplement your other monthly checks. It’s a great planning tool and one that is easy to understand and remember.