As Independence Day approaches, it's a great time to ponder your own financial freedom and how soon you'll get there. A good question to ask yourself in determining that is, "how much money will I need in my portfolio?" The answer to that question depends on how much money you'll need each year, beyond Social Security payments and any possible pension.
What's a safe amount of money to withdraw from your portfolio without risking running out of cash before you die? An old rule of thumb is 4 percent, increasing with inflation annually. That means you could withdraw $4,000 each year for every $100,000 you have saved. While this may not sound like much, if inflation is 2 percent annually, that amounts to $4,080 the second year, increasing to $6,562 a year by year 25. With a balanced portfolio of half stocks and half bonds, you'd have a 90 percent probability of not outliving your money over the next 25 years, based on historical market returns.
But because bonds are paying so little today while stocks are pretty richly valued, many market experts are now predicting lower returns than the historic averages. So I recommend a portfolio spending rate of 3.5 percent, rather than 4 percent. That's for a portfolio of about half stocks and half bonds. (To run the numbers, I used a helpful calculating tool from PortfolioVisualizer.com.)
With a 3.5 percent spending rate, you can withdraw $3,500 for every $100,000 you've saved, and increase it each year with inflation. This means that if you need $10,000 a year beyond Social Security and pension payments, you need a portfolio of just under $286,000. Of course, those who are older and have a shorter life expectancy can spend more.
Some experts argue that it's OK to spend more in the earlier years of retirement because data show that later on, we don't spend as much money on entertainment, recreation and travel. While that's true, there are other expenditures, such as medical costs, that can increase.
See also: 11 Items Cheaper in Retirement
Research indicates that spending more money buys short-term — but very little long-term — happiness. Living on less not only gets you to financial independence sooner, but it also increases the odds that your financial freedom will last your lifetime. I'd stick to the 3.5 percent spending rule in retirement. If you find that that rate is too conservative, you can always boost it later. That's a much easier problem to solve than spending too much and running out of money.
Wishing you all a happy Independence Day, as well as the financial independence to one day pursue whatever gives your life meaning.
Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money Magazine, the Wall Street Journal and other publications. His contributions aren't meant to convey specific investment advice.