Author Topic: Newbie question - Multiply by 25 rule  (Read 4785 times)

thomasmcnamara

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Newbie question - Multiply by 25 rule
« on: May 08, 2017, 07:05:04 PM »
I'm missing some basic fundamental concept here.  It'd be great to know a simple explanation for the effects of inflation in the Multiply by 25 rule...  I see sources that say this accounts for inflation already, and others that say you need to consider the effects of inflation.

i.e. if I want 25k in passive income, I'd need roughly 625k invested.

But if I look at a source like this:
https://www.thebalance.com/budgeting-for-retirement-454001

Simplified to exclude social security and other sources of retirement income, the guide has you account for inflation first, THEN multiply by 25... yielding drastically different numbers, obviously.  In their example, I'd take my 25k, and if I wanted to retire in 10 years, I'd multiply that by 1.48 (per their table, step 5).. then multiply by 25 in step 7.. yielding $925k, instead of the 625k not accounting for inflation.  If I wanted to retire in 25 years the number is obviously much, much higher (1.7 million).

So... what's the correct method for determining how much is needed to save (annually, let's say; periodically) if I wanted to retire in a certain number of years?  Is it just two names for the same thing (625k in today's dollars, 925k in dollars 10 years from now..). 

When I look at an IRA calculator, for example, that tells me that with 11k annual contributions, 7% return, over 25 years will yield me 378k.. and I use the 4 percent rule to figure out how much I could withdraw.. that would mean ~$15k annually.. in future dollars 25 years from now?, so I'd need to think of it in terms of my future expenses (15k/2.67(from 25 years inflation in thebalance.com's table)=5700 in today's dollars..?

I know if I was to retire right now, 625k would lead to the 25k in passive income over time, but how does one calculate over periods of time?  Here's a question posed in the comments section regarding this exact thing, and MMMs response (his response is really what I'm just looking for some clarification on):

http://www.mrmoneymustache.com/2012/05/29/how-much-do-i-need-for-retirement/

Dan: So does that magic number you multiply by 25 apply to todayís money? Say for example I calculate that Iíd need 600k for the retirement following the 4% rule, but what if it would take me 10 years to save that? Does that mean my goal would be basically 600k adjusted for inflation? (600◊1.03^10) assuming my expenses stayed the same (in real money, not nominal)?

MMM: Yes, you can pretty much ignore inflation with this way of calculating things. Because your rate of spending will automatically rise with inflation (and of course drop with optimization).  So in general, if you take your most recent yearís spending, make any adjustments to cover things like health insurance, travel, transportation or other things in your future budget, and multiply that by 25, thatís your retirement nest egg guideline.

MDM

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Re: Newbie question - Multiply by 25 rule
« Reply #1 on: May 08, 2017, 07:27:11 PM »
i.e. if I want 25k in passive income, I'd need roughly 625k invested.
That's actually not what the "rule" means, although it does appear that way at first glance.  See
http://www.retailinvestor.org/pdf/Bengen1.pdf,
https://incomeclub.co/wp-content/uploads/2015/04/retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable.pdf,
https://www.bogleheads.org/wiki/Trinity_study_update, and
https://www.bogleheads.org/wiki/Safe_withdrawal_rates
for some reading.

To your general question, there are two things at play:
1) your spending
2) the growth of your investments.
Whatever you choose to do with inflation, you have to be consistent and do the same for both #1 and #2.

If you use your current spending, then you use "real" growth rates.
If you use your inflated spending, then you use "nominal" growth rates.

Does that make sense?

Tyson

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Re: Newbie question - Multiply by 25 rule
« Reply #2 on: May 08, 2017, 07:37:54 PM »
The idea is that you invest your $$ in something like Vanguard VTSAX (total stock market index fund) which:
1. Grows at 9% on average. 
2. Inflation eats 3% or so so subtract that from your gains
3. Take out another 4% as your yearly living expense

You never run out of money because your expenses (4% withdrawal) and inflation (3%) add up to 7% in total cost per year.  So 9% gains minus 7% expenses/inflation leaves you a 2% buffer.  That way you're alway living off the growth and never off the principal. 


« Last Edit: May 08, 2017, 07:41:13 PM by tyort1 »

maizeman

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Re: Newbie question - Multiply by 25 rule
« Reply #3 on: May 08, 2017, 07:39:27 PM »
The 4% rule (or multiply by 25) adjusts for inflation in your spending each year after you start taking withdrawals, but it doesn't account for inflation between today and the day you have "enough" and retire.

That said, many people find their personal rates of inflation are significantly lower than the consumer price index would indicate. This is particularly true if a big chunk of your expenses are a mortgage payment, which won't increase with inflation (although property taxes and maintenance certainly will). But even if you don't have a mortgage payment in your monthly budget, you will likely continue to figure out new ways to optimize as the years go by to get the same or better life satisfaction with less spending, which would result in reduced spending (and hence a reduced total you need to save) over time instead of the growing spending you'd expect from the consumer price index. Speaking of the consumer price index...

Simplified to exclude social security and other sources of retirement income, the guide has you account for inflation first, THEN multiply by 25... yielding drastically different numbers, obviously.  In their example, I'd take my 25k, and if I wanted to retire in 10 years, I'd multiply that by 1.48 (per their table, step 5).. then multiply by 25 in step 7.. yielding $925k, instead of the 625k not accounting for inflation.  If I wanted to retire in 25 years the number is obviously much, much higher (1.7 million).

Multiplying by 1.48 for 10 years implies 4% inflation each year. Realistically inflation has been closer to 2% since the mid-90s which would mean multiplying by 1.22 for a decade.

Babybalrog

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Re: Newbie question - Multiply by 25 rule
« Reply #4 on: May 09, 2017, 09:43:50 AM »
The 4% rule (or multiply by 25) adjusts for inflation in your spending each year after you start taking withdrawals, but it doesn't account for inflation between today and the day you have "enough" and retire.

Exactly. The 4% rule assumes you are withdrawing money and want it to be flat over 30+ years, only adjusting for inflation.

The x25 rule is how much money you would need to implement the 4% rule Today and retire. But since your spending increases by inflation each year. You need x25 of that you are Going to spend, not what you are Currently spending.

Quote
Is it just two names for the same thing (625k in today's dollars, 925k in dollars 10 years from now..). 
I believe that is correct

thomasmcnamara

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Re: Newbie question - Multiply by 25 rule
« Reply #5 on: May 09, 2017, 03:18:10 PM »
The 4% rule (or multiply by 25) adjusts for inflation in your spending each year after you start taking withdrawals, but it doesn't account for inflation between today and the day you have "enough" and retire.

Ok.  So then in theory you would want to account for inflation and figure the amount you would spend, and maybe use 2% inflation.  So in this case, I'd figure 25k * 1.22 = 30.5k/year spending 10 years from now.  I'd need roughly 30.5k * 25 = 762.5k to safely withdraw 4% 10 years from now.

So then why does MMM say you can effectively ignore inflation?  Sounds like it's just assuming personal expenses would increase more slowly than the CPI.


To your general question, there are two things at play:
1) your spending
2) the growth of your investments.
Whatever you choose to do with inflation, you have to be consistent and do the same for both #1 and #2.

If you use your current spending, then you use "real" growth rates.
If you use your inflated spending, then you use "nominal" growth rates.

That seems to answer my question about the IRA calculator.  If I was determining by current spending (let's say 25k/year), I'd use a real growth rate (6-7%, assuming index fund); if I was determining by future spending (30.5k in 10 years), I'd use the nominal rate including inflation (~9%).  Correct?

It seems like it makes more sense to figure retirement savings by a percentage, rather than a fixed amount, so that it would increase as my wages increased at the rate of inflation.

Thanks all!

secondcor521

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Re: Newbie question - Multiply by 25 rule
« Reply #6 on: May 09, 2017, 03:48:21 PM »
The 4% rule (or multiply by 25) adjusts for inflation in your spending each year after you start taking withdrawals, but it doesn't account for inflation between today and the day you have "enough" and retire.

Ok.  So then in theory you would want to account for inflation and figure the amount you would spend, and maybe use 2% inflation.  So in this case, I'd figure 25k * 1.22 = 30.5k/year spending 10 years from now.  I'd need roughly 30.5k * 25 = 762.5k to safely withdraw 4% 10 years from now.

So then why does MMM say you can effectively ignore inflation?  Sounds like it's just assuming personal expenses would increase more slowly than the CPI.

I think MMM is assuming that you can offset inflation by finding more efficient/effective ways to spend.  So maybe your electric bill goes up by $10 per month one year, but that same year you figure out how to get 2% cash back on a credit card or something.

For what it's worth, I think MMM is largely correct.  In actual dollars, I am spending almost exactly what I spent 10 years ago.

MDM

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Re: Newbie question - Multiply by 25 rule
« Reply #7 on: May 09, 2017, 04:40:08 PM »
If I was determining by current spending (let's say 25k/year), I'd use a real growth rate (6-7%, assuming index fund); if I was determining by future spending (30.5k in 10 years), I'd use the nominal rate including inflation (~9%).  Correct?
Yes, you have it exactly for estimating how you might get from now until retirement.  Apply this reasoning to any pre-retirement questions.

After retirement, the "4% rule" is based on backtesting historical results, including both inflation and actual stock and bond returns.  To the extent the future is no worse than the worst of the past, the 4% rule will work for you.  All the debate is (or should be) about whether the future will be better or worse than the worst stretches in the past.  Reasonable people can differ in their guesses here.

Retire-Canada

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Re: Newbie question - Multiply by 25 rule
« Reply #8 on: May 09, 2017, 05:11:59 PM »
So then why does MMM say you can effectively ignore inflation?  Sounds like it's just assuming personal expenses would increase more slowly than the CPI.

He does it to keep shit simple. I'm planning on a $40K/yr FIRE budget. I may not FIRE for 3-5yrs, but I don't plan to adjust that. My main expense is my mortgage which is not going up due to inflation and I expect I'll find ways to save money when FIREd that I am too busy to make happen now while working. Even when FIREd I will not automatically increase the money I spend each year by inflation just because CPI says things are getting more expensive. I'll spend what I have to in order to enjoy a comparable lifestyle each year. It's possible that with 2% inflation I'll still only pull $40K/yr from my portfolio for the first part of my FIRE until increases in costs outrun my ability to further optimize.

Over the last few years the amount I am spending is going down despite inflation effects so that trend is likely to continue at least for a while longer.

thomasmcnamara

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Re: Newbie question - Multiply by 25 rule
« Reply #9 on: May 09, 2017, 05:57:57 PM »
Ok great, thanks everyone!

Tyson

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Re: Newbie question - Multiply by 25 rule
« Reply #10 on: May 09, 2017, 06:14:47 PM »
My main expense is my mortgage which is not going up due to inflation.....

That is a really good point!  I spend $3500 per month, but $2100 of that is mortgage, and only $1400 is on things that might be subject to inflation.  I don't have to worry about my entire $3500 going up, only $1400.  Which annualized would be $17k that would go up, and $25k that wouldn't.  Interesting!

MDM

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Re: Newbie question - Multiply by 25 rule
« Reply #11 on: May 09, 2017, 08:39:26 PM »
My main expense is my mortgage which is not going up due to inflation.....
That is a really good point!  I spend $3500 per month, but $2100 of that is mortgage, and only $1400 is on things that might be subject to inflation.  I don't have to worry about my entire $3500 going up, only $1400.  Which annualized would be $17k that would go up, and $25k that wouldn't.  Interesting!
One can make a good case for

  "your number" = 25 * "normal expenses" + "unpaid mortgage principal"

maizeman

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Re: Newbie question - Multiply by 25 rule
« Reply #12 on: May 09, 2017, 09:08:44 PM »
My main expense is my mortgage which is not going up due to inflation.....
That is a really good point!  I spend $3500 per month, but $2100 of that is mortgage, and only $1400 is on things that might be subject to inflation.  I don't have to worry about my entire $3500 going up, only $1400.  Which annualized would be $17k that would go up, and $25k that wouldn't.  Interesting!
One can make a good case for

  "your number" = 25 * "normal expenses" + "unpaid mortgage principal"

+1 to what MDM said. (But remember to break out the portion of your mortgage payment going to property tax and home insurance as those two likely will continue to grow with inflation.)

Retire-Canada

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Re: Newbie question - Multiply by 25 rule
« Reply #13 on: May 09, 2017, 09:48:26 PM »
One can make a good case for

  "your number" = 25 * "normal expenses" + "unpaid mortgage principal"

Because of how much mortgage I have left building a 4%WR stash = to the monthly mortgage payments or just the amount left of the mortgage and I end up with the same amount. So I am not breaking out the mortgage. This is not my forever home so I may end up extending the mortgage by buying another house that's more $$ later on.

MDM

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Re: Newbie question - Multiply by 25 rule
« Reply #14 on: May 09, 2017, 10:57:41 PM »
Because of how much mortgage I have left building a 4%WR stash = to the monthly mortgage payments or just the amount left of the mortgage and I end up with the same amount.
Interesting situation.  Can you share specific numbers?  E.g., a 30 year mortgage at 1.25% gives monthly payments that add up to 4% of the principal for the first year, but that's an exceptionally favorable mortgage.

As interest rates increase, or as the years go by and the principal is reduced, multiplying the annual "principal plus interest" mortgage payment by 25 increasingly overstates the amount one needs to save under Trinity study conditions.

Retire-Canada

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Re: Newbie question - Multiply by 25 rule
« Reply #15 on: May 10, 2017, 06:42:28 AM »
Interesting situation.  Can you share specific numbers?  E.g., a 30 year mortgage at 1.25% gives monthly payments that add up to 4% of the principal for the first year, but that's an exceptionally favorable mortgage.

Mortgage Balance = ~$300K at FIRE with 15yrs left [just under 2% variable rate Canada in 5yr terms]
My cost for house after GF paying rent/yr = ~$12K
$300K stash @ 4%WR = $12K

As noted I may need to extend mortgage by adding principal either due to moving to a different house or renovating current old house so the existing mortgage balance may well get bigger. So having $300K extra in investments kicking out $12K/yr gives me the cash flow to address those costs.

One day when I do pay off this house or another house the GF's rent would be reduced to cover ~50% of the actual expenses since she helped me build ~$400K-$500K in equity I won't keep charging her market rent.

MDM

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Re: Newbie question - Multiply by 25 rule
« Reply #16 on: May 10, 2017, 11:07:04 AM »
My cost for house after GF paying rent/yr = ~$12K
Ah, OK, having a separate income assigned to the mortgage payment will make a difference - thanks for clarifying.