In the wonderful novel  “The Hitchhikers guide to the Galaxy” , there is this amazing scene where a gigantic computer called Deep Thought is created in-order to answer a very intriguing question : “What is the answer to the ultimate question of life , the Universe and Everything ?”

After running complex calculations for over 7.5 billion years , Deep Thought finally solves the puzzle.

The answer ?

42

I first though that there must be something I was missing , that there must be a deeper meaning to why the author chose this number.

Turns out , there isn’t.

The biggest lesson  I learned from that scene is that if you ask a dumb question , the wrong question , or a vague question , you will surely get a dumb answer and probably lose a lot of time !

In other words, if we want to get the right answers , we first need to ask the right questions

So when it comes to retirement, the most important question is :

Is there a way to calculate exactly how much $$ I need so that I can retire today and have my money last me for the rest of my life ?

Yes , there is , thanks to the Trinity Study.

The main question tackled by the Trinity Study of 1998 was :

What percentage of my net assets should I live on , to ensure that the money lasts me for the rest of my life ?

The answer : 4%

If every year, you can live on 4% of your retirement savings , then at the end of a 30 year time-period , your portfolio will be intact 96% of the time !

This rule is known as the 4% Rule.

So to get a better perspective , imagine that your expected yearly expenses in the future will be $40,000. 40,000 is 4% of 1 million. Therefore, your aim is to have 1 million $  and then withdraw $40,000 on an annual basis.

Another way to calculate this , is to figure out your expected yearly expenses and then multiply it by 25 , to know how much you will need to retire.

$40,000 * 25 = $1,000,000

You can take anywhere upto 7% on any given year and still be fine. Go any higher than that, and you will probably need to return back to work at some point in the future.

Where does the number 4 come from, in this calculation ? Imagine having a pile of money invested in stocks or other assets – on average they pay you dividends and appreciate at a rate of around 7% per year. Factor in an annual inflation of 3% and you are left with 4% .

The most common objection to this calculation is that stocks can go up and down on any given year.

That is true – but we are not talking about investing for a few years. We are talking about investing money for decades , knowing that the stock market always goes up in the long term. In fact , make the most of market drops by investing even more aggressively during these golden opportunities. Ideally , you should be as motivated and excited about getting stocks at half-price in the next market crash as you are  about getting that new Laptop on the next Black Friday Sale.

So do I just save 1 million $$ ?

No.

Saving 1 million $ is not a great idea, because it not only fails to earn you more money but over the years, loses it’s buying value due to inflation.

The secret is to invest the money in a portfolio of Stocks and Bonds , but mainly Stocks.

I would suggest 80-90% in stocks and 10-20% in bonds.

Yes , bonds are a deflation hedge and are needed to reduce volatility but a high ratio of stocks is crucial to the survival of your portfolio.

How many years will it take me to retire ?

The answer to that depends on your savings rate , for two reasons.

1. If you save more, you will be able to increase your portfolio faster
2. Since your retirement amount =  25* Projected Future Annual Expenses , reducing the expenses will mean a lesser amount would suffice for retirement

So what percentage of your income are you going to save and invest ?

If you save 50% of your income, you will only need to work for 17 years .

Bump it up to 66% and you only need to work for 10 years.

Go higher to 75% and you only need to work for 7 years !

What stocks should you buy ?

I highly suggest investing the majority of your portfolio in low-cost index funds like the Vanguard S&P Index Fund or Vanguard Total Stock Market Index Fund , but more on that in a later post.

For now , the key points to remember are :

1. The sooner you invest and the greater the % of money you invest, the earlier you will be achieve financial independence
2. Challenge yourself to achieve at-least 50% of your income or , if you are up for it , 66% of your income
3. You probably will create additional sources of income in your retirement years .If you think that will be the case , you can factor that in and retire a bit earlier
4. When you can live on 4% of your investments per year, you are financially independent

Action Items for You :

1. Calculate your projected future annual expenses
2. Calculate your financial independence amount by 25 * annual expenses
3. Honestly answer to yourself as to what your current savings rate is
4. Calculate how many years it will take you to reach your goal of financial independence at your current savings rate
5. Calculate the maximum savings rate that you can aim for. Be creative. Cut out the Starbucks and cable TV if that would mean financial freedom 5 years sooner
6. Calculate how many years it will take you to retire at your new savings rate (Factor in a 5% rate of return on your investments after inflation). To do this , go to Vanguard Retirement Income Calculator or search for retirement calculators online and enter in your income , savings rate , annual retirement expenses , expected return on investment, expected rate of inflation to get a more accurate estimation

What I like the most about the 4% Rule is that it gives us something to aim for , it gives us a clear definite goal that we can visualize and work towards. We are no longer running around in circles. We know where we are headed, and we know how to get there faster if we choose to.

And that, is awesome !