The 5% investment rule you should know about

If you're young, you're probably not thinking too much about retirement but the latest statistics released from the ATO (2021) show that in Australia, the average retiree income is less than $20k - around 21% of the average income of a full-time worker. 

Based on these figures, the reality is that most people will have to drastically cut costs and make considerable lifestyle sacrifices in their later years, a pretty frightening prospect for many people. But, with the right approach, this predicament is avoidable. 

The 5% rule unpacked

The 5% rule says that you can generate an income of around 5% from investments each year without eating into your capital (reducing your balance). So, for example, if you have $1 million invested, you should be able to derive an income of around $50,000 each year for the rest of your life. 

This is based on long-term returns on investments of 9.8%. After allowing for fees and inflation, you're left with 5%. The 'rule' is a rough estimate and although it isn't perfect, it's generally dependable enough to help you set solid money targets. 

Knowing how much income your investments can generate allows you to calculate how much you need to have in investments to achieve smart money freedom. 

Setting your 'smart money freedom' target

For the final piece of the puzzle, you will need to set a clear target of how much income you want or need in the future. This is your 'smart money freedom' income. 

Setting targets will help you understand exactly where you want to get to and to be clear on how big your smart money freedom gap is. To use the 5% rule to set your targets, think about what your ideal level of income for the future would be. 

I get that retirement can seem a long way away and it can be hard to figure out what the right number might be. You'll probably do some more work on this number over time, but you don't want to get stuck at this point. Your current income level is a good place to start. 

Once you have your income target number, simply divide the number by 5% to get your investment balance target.  

For example, if you want an annual investment income of $100,000, you can use the 5% rule as follows: $100,000 / 5% = $2,000,000 

This means to achieve an income of $100,000 a year in the future, you'll need to have around $2 million in investments, so this becomes your target.

Note that your smart money freedom income will tell you how much money you need to have in investments, not including your home. While your home is an asset, and some would consider it an investment, it won't make you any money until you sell it. So your true smart money freedom target is how much you will need in investments excluding the value of your home.  

Calculating your 'smart money freedom' gap

To work out your 'smart money freedom' gap, start by calculating your net asset position today. Let's look at a hypothetical example:

When calculating your net asset position today without including your home, the net asset value may be negative. This is common for homeowners and shouldn't throw you off. As explained, your home is excluded from your investment assets because it doesn't provide an income. However, the debt needs to be included because it will need to be repaid eventually. 

The next step is to use your current financial position to work out your smart money freedom gap - that is, how much more money you'd need today to be completely financially free. For example: 

• Net investments target ($100,000 @ 5%): $2,000,000 

• Dream home target: $850,000  

• Smart money freedom target (investment home value) = $2,850,000 

• Total net assets: $455,000  

• Smart money freedom gap (Smart money freedom target - total net assets) = $2,395,000 

This can be used as a starting point to get a solid sense of where you are today, where you want to take your money, and the gap reflecting the work to be done. Becoming clear on this is an important step in framing your thinking to start your journey and is something you should refer back to regularly as you proceed. 

This is an edited extract from Virgin Millionaire: The step-by-step guide to your first million and beyond (Wiley, $34.95), republished with permission and available at all leading retailers.