Most people wouldn't mind retiring early, but how do you know when you can afford to? Well, one rule can help you figure out whether you're ready financially. We take a look at the 25x rule.
The 25x rule
The 25x rule tells you how much you need to retire on based on your current living expenses. If it costs you $30,000 a year to live, the 25x rule says you need an investment portfolio of 25 times this to retire on. This means you'll need $30,000 x 25 = $750,000.
The 25x rule assume you will be able to make a real return i.e. a return after inflation, of 4% from your investment portfolio. This means you can afford to take out $30,000 of your portfolio in your first year of retirement without impacting your principal. The next year you can take out the same amount adjusted for inflation.
The problem
The 25x rule relies on generating 4% real returns per year. In reality, many retirees are invested in lower risk assets such as bonds. In our current low rate environment returns on these investments are often below 4%, which means after inflation real returns may be negligible.
ASX shares can offer higher returns; Westpac Banking Corp (ASX: WBC) currently has a dividend yield of over 7%, while AGL Energy Limited (ASX: AGL) has a dividend yield of 5.69%. Of course shares are considered a riskier asset than bonds.
The solution
If real returns are less than 4%, the 25x rule will no longer apply. If, instead, real returns of 3% are expected, the 25x rule becomes the 33x rule. If you need $30,000 in income, you should have $30,000 x 33 = $990,000 in assets to retire. You can adjust the rule according to the level of returns you expect on your assets.
The return on your investments, and therefore the growth of your portfolio, will be dictated by the types and mix of assets invested in. Investors with long time frames can afford to take higher risks as they have a longer period to make up for any losses. Investors close to retirement will tend to have a more conservative portfolio which seeks to minimise the risk of major capital loss.
Foolish takeaway
Knowing how much you need to retire can help you plan ahead and add meaning to your investment journey. This simple rule can give you a yardstick of what you need to cover your living expenses in retirement.
