Estimating Your Needs for the Future: The Rule of 25

I’ve got a theory that you can’t get where you’re going if you don’t know where you want to go. Oh, I know someone else said that much more elegantly than I. This week I’m going to explore four common theories on setting your nest egg goals. Sure you can use calculators, but they can be complicated and cumbersome. The four methods I’ll cover simple yet great for setting tangible goals.

Today’s method: The Rule of 25

A simple explanation for the Rule of 25 is to add up your annual expenses, multiply by the number 25, and, voila, you get the amount you need for retirement. But it can be more complex than that. For one thing you’ll need to determine if your expenses today are comparable to what you’ll need in the future. If you are young and single you’ll probably need to increase the annual expenses a bit to compensate for your plans. Do you hope to have a family? pets? own a home?

Let’s look further at this theory. It’s just a mathematical simplification of the famous 4% rule where you expect to spend 4% of your savings during each year of retirement.

The rule assumes that you will be able to generate an annualized real return of at least 4% on your investments. A return of 4% return on a portfolio of $1.25 million yields $50,000. If you needed $40,000 to live on, you would need to save $1 million. If you needed $60,000, you would need to save $1.5 million. The amount you need to save to generate a specified annual income is always 25 times the annual income amount as long as you assume a 4% real return on your investments.

If your expectations for returns differ you can adjust the theory. Many people will downgrade the real return to 3% in which case you would then multiply by 33, instead of 25. Or multiply by 20 if you expect a 5% return. The more conservatively you approach the estimation, the more chances of success you will have, because you’ll sock away more savings.

Another way to apply the Rule of 25 is toward your current expenses and savings. If you take a look at an expense, say $4.00 each week for a latté which over one year would cost $208. Then multiply that expense by 25 you’ll find that for you’ll spend $5,200 during your lifetime on that treat. You might use this method to evaluate whether or not an expense is worthwhile.

So, the Rule of 25 is rather simple. It definitely gives you a goal to shoot for and I like that you can use it evaluate other savings and spending areas. Give it a try and then compare to some other theories that I'll cover this week.