Financial advisors disagree over how much money the average person needs to retire, but many base their calculations on their client’s annual income, on the assumption that everyone spends most (if not all) of their income. But there is a growing case being made by personal finance experts that retirement calculations should be based on a person's annual spending, and that the average person can retire and live more-or-less forever with a nest egg of 25 times their annual spending. For example, if you spend $30,000 per year, you could theoretically retire once you have $750,000 saved and invested, and your investment portfolio would (in most mathematical scenarios) last forever.
How does that work? Invested money theoretically earns a return for you every year, and as long as you spend less each year than the return on average, the nest egg just grows larger.
Consider an oversimplified example. Joan invests $750,000 in the stock market, which earns for her a return of 8% annually. Now, some of that is wiped out by inflation – let us say 2.5% – so her return in actual spending power is 5.5%, or $41,250, which is great, because that is more than she spends!
Real life is of course messier; one year, the stock market may crash by 15%, and in other years (like 2013) it may be up 29%. Inflation may hover around a low 1% (like it did in 2013), or surge up by 6%. But long-term averages suggest that a 7-10% return from the stock market is reliable and realistic. (“But wait,” you say, “long-term averages are all well and good, but what if the stock market crashes the year after I retire?” Glad you asked – a large-scale economic study known as the Trinity Study actually looked year-by-year at what would happen to a person’s theoretical nest egg, adjusting for inflation, using a 4% withdrawal rate.)
But what if some of that $750,000 starting nest egg is in income-producing investments, like bonds or rental properties? Imagine Joan puts $100,000 of her nest egg in reasonably safe bonds, with an unimpressive return of 5%; she receives a more-or-less guaranteed income of $5,000 from it each year, without having to withdraw money from her portfolio by selling anything. The value of her bond is, however, cut each year by inflation, so while she earns 5% income, she also loses 2.5% on inflation, for a real-dollar return of about 2.5%.
Joan, as it happens, is also a landlord, and invested another $150,000 of her nest egg in three rental properties, each of which rents for $1,000/month. Not all of that is profit, of course – Joan still must pay for real estate taxes, property insurance, the occasional unexpected repair and vacancy. Of her annual rental income for each property of $12,000, take away $2,000 for taxes and insurance, and another $2,500 for unpredictable expenses like vacancies and repairs, for a net annual income of $7,500 per property ($22,500 total). Good news here though: rents grow alongside inflation, so there is no need to pull out the 2.5% for inflation.
Something happened to the math just now. With an investment of only $150,000, Joan covered three-quarters of her yearly expenses of $30,000, receiving a net rental income of $22,500 annually. It suddenly seems like she actually only needs another $7,500 of income each year – so the 25X rule would indicate that she can actually retire on only $187,500 more, rather than $600,000 more.
Not everyone would feel comfortable with so much of their portfolio invested in rental properties. But for experienced real estate investors who know what they are doing, they are low-risk, high-return investments; the experienced rental investor is able to buy at a low price, knows how to properly screen their tenants to avoid rotten apples, and includes liability coverage in their property insurance. This changes the math for retirement entirely – instead of needing $750,000 to retire, Joan only needs $337,500. Nor did Joan achieve unusually high ROI on her rental properties, buying each property for $50,000 and renting them for $1,000. Experienced real estate investors can and do find better deals all the time; consider this amusing tale of one landlord's 29% ROI on his rental investment.
If Joan invested $150,000 in the three rental properties, another $100,000 in stocks, and $87,500 in bonds, her annual return may look something like this:
- $22,500 in rental income
- $2,000 in stock dividends
- $6,000 in capital gains on stock appreciation
- $4,375 in bond payments
For a whopping $28,875 of that income, she does not have to withdraw money by selling any of her positions – her underlying investments retain all value (except inflation, in the case of her bonds’ face value). She can choose to spend $1,125 less and leave all of her stocks alone and let them continue appreciating, or she can sell a few shares, but even so her stock portfolio would still be worth $4,875 more than when the year started. Her net worth is higher at the end of the year, and that does not even include the appreciation in value of her three rental properties.
If Joan could manage to stash away only $337,500, she could live forever on her investment income. Someone earning $60,000/year who spends only $30,000/year could therefore retire in only seven years, if they invest the other $30,000 and reinvest all of the returns during those seven years (try it yourself with this compound interest calculator).
For a more extensive review of the 25X rule of retiring, personal finance blogger Mr. Money Mustache makes a strong (and amusing) case for it on his blog, and goes into deeper depth on safe withdrawal rates.