Whether you are pursuing financial independence and early retirement or planning for a standard retirement in your 60’s, you need to answer a critical question; “how much money do I need to retire?” In this article, I am going to review how a simple rule of thumb known as the 25x (or 25 times) rule can help answer that question. I’ll also discuss how the 25x rule needs to be amended for those planning for early retirement.
How much money Is enough to retire?
It’s one of the most important questions in our financial life. Getting it wrong can have serious implications. If you save too little for retirement, you’ll need to choose two terrible options;
1. Working longer than you planned
2. Living on less money in retirement
If you have no idea how much, you’ll need in retirement it’s also possible you’ll save too much money. You might be thinking that saving too much money doesn’t really sound like a problem. To a certain extent that is true. If I had to pick between saving too much or too little, I’ll choose saving too much 10 times out of 10.
However, by saving too much money you could end up working for years longer than you needed to. Saving too much money isn’t a big deal if you love your job. The less you like your job the more of a problem saving too much money becomes. If you hate your job and end up working until your 65 when you could have retired by 50, then you have wasted 15 years doing something you hate. The saddest part is that with a little planning that could have been easily avoided.
It is critical to at least be in the ballpark when answering that important question “how much I need to retire?” Fortunately, you don’t have to be a financial guru to estimate how much money you’ll need. Enter the 25x rule.
The 25x rule
The 25x rule is quite simple, it states that you need to save 25 times your annual expenses to retire.
Note that is not 25 times your annual income, but 25 times your annual spending. The key piece of information you will need to figure out is how much do you expect to spend in retirement?
Keeping in mind some major expenditures such as your mortgage and saving for retirement could be gone. While at the same time other expenses such as medical costs and travel will increase significantly in retirement.
An example of the 25x rule
Let’s say I want to retire in 5 years. After tracking my current expenses and projecting my future expenses I think that I will need about $30,000 per year to maintain my current lifestyle. According to the 25x rule, I will need at least $750,000 to fund my retirement.
Remember, the 25x rule states that the amount of money needed to retire = annual expenses x 25. In my example, that amount of money I need to retire is $30,000 x 25=$750,000.
The more frugal you are, the less you would need to have saved up for retirement. If you want to increase your annual spending in retirement, you’ll need to stash away a lot more money.
If I wanted to spend $100,000 per year in retirement, I would need to save $2.5 million ($100,000 x 25).
This illustrates an important point those pursuing Financial Independence understand; the more frugal you are, the quicker you will be able to retire.
Assumptions & Limitations of the 25x Rule
Like with any rule of thumb, the 25x rule uses some assumptions and has limitations best we discuss them. The 25x rule has the following assumptions”
The 25x rule assumes you have no other sources of retirement income.
This includes income from a defined benefit pension, social security, government-sponsored pensions or rental income. So, if you have any of these things to fund part of your retirement your personal retirement savings could be smaller than 25 times your spending.
In my previous example I mentioned I would have $30,000 in annual expenses during retirement and that according to the 25x rule, I would need $750,000 to fund that retirement.
What if I have a defined benefit pension plan that will pay me $16,000 per year in retirement? Since I have the first $16,000 of my retirement savings covered by my pension, I would only need to fund $14,000 per year using my personal savings. That means I would need to save $350,000 ($14,000 x 25) to top up my pension income in retirement.
Investment assumptions used in the 25x rule.
The 25x rule also makes some assumptions that your retirement savings will generate at least a 4% annual rate of return above inflation. That means if inflation is 2% your investments would need to return 6% per year. Otherwise, you could be at risk of running out of money in retirement.
A word of caution for those pursuing early retirement
The 25x rule and its counterpart the 4% rule are based on the findings of 1994 paper in the Journal of Financial Planning by William Bengen.
In his study, Bengen used U.S data and built a hypothetical portfolio of 50% stocks & 50% bonds to find the highest sustainable withdrawal rate for a 30-year retirement. To do this he modeled the returns of this portfolio for every 30-year period from 1926 to 1992.
The relevant finding in Bengen’s study was that the 25x rule represents the minimum amount needed for a 30-year retirement. This presents a problem for those pursuing early retirement. If you retire in your 40’s or 50’s and you expect to live well into your 80’s or longer the 25x rule may not apply.
If you are planning on living on your retirement nest egg for longer than 30-years, you will need to save more money. Rather than saving 25 times their annual spending, early retirees might consider saving at least 30 times their annual spending.
Returning to my example where I want to retire on $30,000 per year. For a traditional retirement, I can use the 25x rule and plan to save $750,000. For early retirement, I might use the 30x rule and plan to save $900,000.
I want to be clear. The 25x rule is an oversimplification. However, it is a useful rule of thumb to quickly get you in the ballpark for how much you’ll need to have saved for retirement. My advice would be to use the 25x rule as a starting point for your retirement planning. It should not be the only analysis you do when considering how much to save for retirement.