This past Thursday, I had the pleasure of speaking at the IDOC conference in Orlando about the math behind selling a practice to Private Equity or holding onto the cash flow and which is better financially.
Anytime I talk with ODs close to retirement, whether it be selling a practice to Private Equity or their associate, I always ask one question: do they have enough to retire on comfortably for the rest of their life? This is going to sound like a no-brainer, but knowing that is pretty important before giving up your primary source of income! This is where the 4% rule can be a helpful starting point.
What is the 4% rule?
The 4% rule is this: on a pool of investments, 4% is a long-term sustainable withdrawal rate through retirement. So if you have $1,000,000, theoretically that should provide an ongoing lifestyle of $40,000 for about 30 years. Let me repeat that: $1,000,000 generally speaking will provide $40,000 per year during retirement.
The 4% rule as an acid test
Don’t have $1,000,000? Spend more than $40,000? Use 4% as a quick acid test on what your wealth gap (the difference between what you have and what you need for retirement) looks like.
In my experience, the 4% rule is best applied in reverse—taking your annual spending (let’s say $200,000) and divide it by 4%: $200,000 ÷ .04 = a $5,000,000 investment portfolio needed to retire. All retirement plans should start with annual spending, which almost always initially INCREASES at retirement. I encourage you not to think you can easily live on a reduced budget.
When does the rule work?
The good news is that the 4% rule almost always works for an average person at an average retirement age. In fact, historically speaking 66% of the time the 4% rule doesn’t wind assets down to $0 from retirement age to death, the initial investment amount actually increases over that same period of time.
When doesn’t the rule work?
Here’s the bad news: the research around the 4% rule demonstrates that it doesn’t necessarily work when investment valuations (such as the price of an stock compared with the income that asset generates) are at all-time highs. Like right now. For example, the 4% rule didn’t work for retirees who calculated their retirement on that principle in 2007.
Another exception: early retirement. The 4% rule also doesn’t hold true for retirements that last 40 years or more (so retiring before age 60). That sustainable withdrawal rate averages is closer to 3.5%. My FIRE readers, use 3-3.5% for your calculations.
There is a better way
Financial planners like myself typically have access to sophisticated planning tools that not only account for annual spending, asset type/taxability, what you’re invested in and external variables like fees and inflation. The most accepted analysis (called a Monte Carlo analysis) actually develops a probability of success after stress testing all these variables through different market cycles.
Comparing your spending and investment portfolio using the 4% rule is a great way to quickly calculate if you’re on track for retirement. But in my opinion, making sure you have enough money to last the rest of your life is too important to leave up to a rule of thumb.
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