Making Sense of the 4% Rule
It doesn’t take long for anyone researching retirement to hear about the 4% rule. There have been hundreds of articles written about it, many of which provide incredible detail around the history of the 4% rule, the mathematics behind it, and special considerations for those pursuing early retirement.
I’m not going to reinvent the wheel here today.
Instead, I’m going to share some basic information about the 4% rule, include links to several resources that provide much more information for those who are interested, and discuss our potential use of the 4% rule on our path towards early retirement and financial independence.
According to the usually helpful Investopedia, “the four percent rule is a rule of thumb used to determine the amount of funds to withdraw from a retirement account each year. This rule seeks to provide a steady stream of funds to the retiree, while also keeping an account balance that allows funds to be withdrawn for a number of years. The 4% rate is considered a “safe” rate, with the withdrawals consisting primarily of interest and dividends.”
The 4% rule was first popularized around 1994 by financial advisor William Bengen, and then validated by the 1998 Trinity Study by professors Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz. Their work was subsequently updated by Wade Pfau in 2009.
Both the Trinity Study and Pfau’s subsequent research looked at historic investment returns and inflation. They found that in the vast majority of past scenarios, a 4% withdrawal rate on retirement assets in a portfolio consisting of 75% stocks and 25% bonds would have funded a retirement for at least 30 years.
Now there’s nothing inherently magical about 4%, besides the fact that it’s a whole number, and the probability of past success using it as a withdrawal rate would have been high.
If you wanted to be more conservative, you could use 3.5% as your withdrawal rate, and further increase the chance your funds would last for 30 years, or longer. If you wanted to be more aggressive, you could use 4.5% as your withdrawal rate, which would increase the amount you have available to spend early in retirement, while also increasing the probability you run out of money earlier than you had planned.
Keep in mind that there are no guarantees with any potential withdrawal rates. Depending on where the financial markets go in the coming decades and your specific circumstances, a withdrawal rate of 3% or lower might not last as long as you need it to.
As an aside, while researching early retirement and the 4% rule, you may have also heard about the need to save 25x your annual expenses to be able to afford retirement. 4% and 25x are related to one another, in that 1, divided by 4%, equals 25.
If you believe in the 4% rule and are retiring today, you can determine what you can spend during your first year of retirement by multiplying your net worth times 4%. If you believe in the 4% rule and are planning for a future retirement, you should multiply your anticipated annual spending in retirement by 25 to determine what your net worth needs to be when you retire.
For example, if you are retiring today and have $600,000 in assets, the 4% rule tells us you can afford to spend $24,000 a year ($600,000 times 4% = $24,000). If you want to retire in the future and expect you’ll require $50,000 a year to live on, you will need to save $1,250,000 ($50,000 times 25 = $1,250,000).
Similarly, if you want to be more conservative and use a withdrawal rate of 3.5% in retirement, you’ll need to save 28.6x your annual expenses, rather than the 25x your expenses associated with a 4% withdrawal rate. If you are more aggressive and plan on a withdrawal rate of 4.5%, you’ll need to save roughly 22.2x your annual expenses before retiring.
As potential early retirees, the other thing we must consider is whether a 30-year timeframe is appropriate. Mrs. ROMT and I are both in our mid-40s right now. We calculated our life expectancies using MetLife’s Life Expectancy Calculator. My life expectancy is currently about 32 years, while Mrs. ROMT’s is about 36 years. Given that we have four more years until our target FIRE date, a 30-year timeframe sounds reasonable, right?
We need to keep in mind that life expectancies are just averages, and there is a 50% chance I will live for more than 32 more years, and a 50% chance Mrs. ROMT will live for more than 36 more years. When you’re funding a retirement for two, the other thing you need to anticipate is how long at least one of you will remain alive (your joint life expectancy). According to the MetLife calculator, there is a 50% chance at least one of us will live for another 41 years, and a 25% chance one of us (most likely Mrs. ROMT) will live at least 46 more years!
That is good news. But does it mean we should throw the 4% rule out the door?
In our situation, I don’t think so.
The Mad Fientist has a comprehensive post on safe withdrawal rates for early retirees, in which he notes the biggest risk to a potential retirement portfolio is sequence of return risk. Essentially, if real returns in the first decade of your retirement are sound, you are probably in good shape for a long and prosperous retirement. If real returns for your first decade of retirement are poor, you may need to adjust on the fly, by cutting spending and/or heading back to work to earn more money. Mr. Money Mustache writes that “the sequencing of booms and crashes matters” in his detailed post on the 4% rule. Moreover, he notes that “above 30 years, the length of your retirement barely affects the safe withdrawal calculations.”
While we all need to make our own decisions, the analysis done by The Mad Fientist and Mr. Money Mustache does give me some comfort around buying into the 4% rule as the right retirement spending target for our family.
And even though we are targeting 25x our expected annual expenditures as our financial independence target, we are building some extra conservatism into the numbers, to give us a (theoretically) higher probability of success.
First, we are not including the equity in our home in the net worth calculation we are using for early retirement. Unlike the rest of our financial assets, our home does not generate any income for us. Yes, we need a place to live, but in the future, we could downsize or move to a lower cost area to unlock additional funds to finance our retirement.
Second, while our goal is to reach financial independence while we are still in our 40s, that doesn’t mean we’ll never earn any additional money by working. Early retirement to me means the potential freedom to work on what I want, when I want. I can see myself writing, consulting, teaching, and/or working on projects I find interesting after I have left the 9-to-5 (or more often 7-to-6!) grind. Any money earned during retirement, even just a few thousand dollars a year, will increase our probability of success.
Third, you may have noticed I haven’t mentioned potential Social Security benefits. There is a ton of debate about the future of Social Security in the United States, but the numbers may not be as bad as some assume. Last year, Carolyn Colvin, then the Acting Commissioner of Social Security, posted that the Social Security Board of Trustees 2016 Annual Report indicated that, as a whole, Social Security is fully funded until 2034, and about three quarters financed after that.
In twenty years, do I expect to receive exactly what is listed as my estimated benefit on my annual Social Security Statement from the Social Security Administration?
In twenty years, do I expect to receive nothing from the Social Security Administration after contributing to the system since the late 1980s?
I am not factoring potential Social Security benefits into my retirement calculations at this time, but I do expect to receive something, someday, which will further improve our margin for error in retirement.
Fourth, the calculations behind the 4% rule assume we will spend at that level (adjusted for inflation) every year in retirement. While our expected annual retirement spending level is not extravagant, it should be comfortable, and there would be potential for us to cut some costs if our portfolio does not perform as expected early in retirement. Adjusting our spending downwards from our expectations, even just a little bit, could help us offset potential sequence of return risk. Moreover, there is evidence that suggests spending tends to decline during retirement.
Given the historic success of a 4% withdrawal rate, the conservative way we are calculating our net worth, the potential to earn additional money and receive some Social Security benefits in retirement, and our ability to cut spending if needed, I am comfortable using the 4% rule as the basis of our early retirement calculations. As I mentioned earlier, if you want to be more conservative, you can certainly use a lower withdrawal rate, and you should consult with your financial advisor before making any major decisions about your finances.
Are we being too optimistic or too conservative in our assumptions as we pursue financial independence? What do you consider a safe withdrawal rate for early retirement?