Q. - What is the 25X Rule?

A. - Read enough online blogs or articles, and you’ll come across the 25X Rule, which states that by accumulating 25 times your living expenses in savings, you would (theoretically) be financially independent. It’s often discussed as the basis for F.I.R.E., or the Financial Independence Retire Early method, and it’s a simple metric for determining whether your savings could support all your expenses, allowing you to retire, start a business, or pursue more meaningful work. In numbers, here’s an example. If you need $40,000 for living expenses, save 25 x $40,000, or $1,000,000, and you’ll be able to cover your living expenses from investment income, never drawing down principal. In other words, $1,000,000 x .04 = $40,000, and 4% income from investments produces the needed income. If you use the rule at normal retirement age, when claiming Social Security, it applies only to expenses not covered by Social Security. In the example, if $24,000 is provided by Social Security, then $16,000 x 25 = $400,000 in savings is needed.

Maybe you can see 3 problems with this “rule”. First, living expenses of only $40,000 are challenging today, even in the lowest-cost places in the country. You would need sub-$1,000 rent, subsidized health insurance, a paid-off car, or good public transportation. This is extremely risky given the potential for 5% inflation for another year or two, or emergencies that require more than $40,000 in some years. The lower the estimated living expenses, the greater the impact of small emergencies, new fees, taxes, or expenses, and the harder it is to absorb those impacts. Thus, if one thinks they’ll need $40,000, they should probably plan for $45,000 or $50,000 instead, which would require more than 25X.

Second, to keep up with inflation over time, you would need to increase the income needed, making it even more challenging to grow investments to stay ahead. While taking 4% in income, the portfolio also needs to grow by 3% to keep up with inflation, for a total portfolio return of 7%. Some FIRE proponents point to portfolios that will return 9%, which is far from guaranteed. And sure, if your portfolio returned even 7% for a decade while withdrawing no more than 5% or 6%, your balance would increase. But a consistently returning 7% is unlikely, and taking out 4% every year makes it even harder to recover from the annual losses that are bound to occur from time to time.

Finally, there is the impact of time. Not just on growing investment balances, but also on your ability to earn income and have that income provide a larger Social Security benefit, and maybe an employer contribution to retirement and health care. Once your peak earning years are gone, they’re gone. Anyone who achieves 25X in their 30’s or 40’s and thinks they can retire hasn’t considered the financial realities of old age. Besides health challenges that come with aging, other setbacks will demand resources. Being employed puts you in a better position to address life’s challenges. Ever try to get a loan with no income? Any early retirement comes with risks that can only be addressed by having more resources, not just income that covers expenses.

Therefore, the 25X rule is a useful measure of your independence from the chains of employment. It can allow you to start a second career early, even with a pay cut, because you’ve built up a cushion to lean on. As you save toward that 25X expense goal, I believe you’ll gain financial resiliency against life’s challenges, not financial independence. Given that 25X savings may or may not cover your expenses today and still leave you short tomorrow, I’d rather think of the 25X rule as a “rough rule of thumb” to understand the magnitude of what it takes to approach financial independence.

Learn more about getting started saving for retirement in What Would Dad Do? - Volume 1: Essential Money Management, climbing the retirement savings hill in What Would Dad Do? - Volume 2: Investing and Climbing the Retirement Hill, and retirement readiness in What Would Dad Do? - Volume 3: Top of Retirement Hill Through Old Age