The 4% rule of thumb is a handy tool to guide many aspects of financial planning. We will discuss a few of them below:
Size of your target corpus:
Once you have an idea of most of your current annual expenses (recurring as well as one-time), multiply by 25 to determine a target investment corpus. What can be measured can be improved, so the biggest advantage of the 4% rule is that you are able to focus on growing this corpus and accelerating your path to independence.
Date of financial independence:
You can compute an amount you can systematically invest on a monthly basis once you have an idea of your monthly cash flows (salary/ business income inflows and expense outflows). You may assume a conservative growth rate for your investments, and the date the size of your investment corpus exceeds the size of your target corpus is your estimated date of financial independence.
Spend or Invest decisions:
For every significant expense, you can pause before you pull the trigger and make the purchase. If you plan to retire in ten years, the 4 lakh every year that you spend on vacations till then can instead be invested in the market (returning, say, 10%) to allow you to withdraw INR 21,000 every month after ten years for the rest of your life. While that INR 21,000 ten years from now may be worth only 11,865 in today’s rupees considering a 6% inflation, you can make a judgement call whether you would value a ten ten-day holidays higher than a 20,000+ monthly cash flow for the rest of your life.
Fast-tracking your target date:
Having a clear goal enables you to optimize your path. By reducing your significant and/or recurring spends over time, you can advance your target date. If you invest the amount of money you forego spending on, you can estimate how sooner you can be independent. In parallel, if you crimp your spending to a lower amount by targeting your significant and/or recurring spends, the required investment corpus is automatically lower, again bringing forward your retirement date. Once this becomes a habit, you may identify many extraneous spends that were in effect, keeping you in the hamster wheel for longer than you should have been.
Shift from Net income to monthly investment:
We tend to evaluate the size of a purchase by the number of days we would need to work to earn the amount being spent, after tax. But once we shift our focus to the investments we make on a monthly basis, the time horizon gets magnified, providing a truer picture of the cost of the purchase. For the travel example above, if we earn 1 lakh a month after tax and save 30% on a monthly basis, four lakh represents four months of income, but over a year’s worth of foregone investments and consequently the true cost of what you are paying is clearer.
In summary, the 4% rule brings in clarity and a simple long term goal to focus on while you count down your days to financial independence.