An Introduction to the 4% Rule, Part 1
How to understand the most popular safe withdrawal rate.
Anyone planning for retirement must answer a critical question: How much do I need to save?
If you don’t know how much you need, you’re flying blind through your working years and run the risk of not making it to your retirement goal. If you don’t save enough, or you cut it too close, you could end up outliving your money at an age when going back to work may not be an option.
You can’t know how much you need to accumulate in investments unless you first figure out how much of your portfolio you can safely withdraw in retirement.
What Are Safe Withdrawal Rates?
A safe withdrawal rate is the percentage you can withdraw from an investment portfolio without depleting it during your lifetime. Carefully choosing your safe withdrawal rate increases your chance of success. In this case, success in retirement means you can sustain your desired level of spending till the end of your life.
You have to take a number of factors into consideration when determining a safe withdrawal rate: expected rate of return, inflation, taxes, your spending needs, your lifespan, and more. The safe withdrawal rate attempts to minimize the negative impact of these factors to ensure you don’t outlive your money.
Withdrawal rates don’t just matter for retirement. They also help determine when you’ve reached financial independence, or when work becomes optional. Fortunately, there’s lots of academic research out there that helps determine a safe withdrawal rate in retirement.
The 4% Rule
The 4% rule is a rule of thumb for safely withdrawing from a retirement portfolio. According to the 4% rule, you can withdraw 4% of your portfolio in the first year of retirement and increase that amount every year with inflation for the rest of your life and not run out of money.
The rule originates with retired financial advisor William Bengen, who published a paper in 1994 which looked at stock and bond returns over 30-year periods from 1926 to 1974 and determined that even in the worst 30-year period, a retiree invested in a portfolio of 50% stocks and 50% bonds could withdraw 4% of their portfolio without running out of money.
In other scenarios a retiree could have withdrawn as much as 7% of their portfolio and have been fine. And for time periods longer than 30 years, a 3% withdrawal rate was safest. But taking into account bear markets and extended periods of negative stock returns, Bengen’s research arrived at 4% as the optimal withdrawal rate for the worst-case scenario over a 30-year period, and that’s the number media and financial advisors ran with.
In 1998, a paper by three finance professors at Trinity University published a paper known as the Trinity Study which more or less confirmed Bengen’s findings endorsing a 4% withdrawal rate in retirement.
The Trinity Study looked at various stock and bond mixes with and without inflation adjustments over 15- to 30-year periods between 1925 and 1995. While Bengen’s study determined the highest safe withdrawal rate given the worst-case scenario, the Trinity Study sought to find the success rates for various combinations of asset mixes, withdrawal rates and time periods.
The study found that a scenario where a retiree with a 30-year time horizon and a 50/50 stock and bond allocation using inflation-adjusted withdrawals of 4% of the starting portfolio value had a success rate of 95%. The success rate increased to 98% assuming the retiree invested in an allocation of 75% stocks and 25% bonds — much more aggressive than is often recommended to retirees.
An update to the study in 2014 conducted by Wade Pfau, a retirement income expert and professor at The American College of Financial Services, found that a 30-year retirement with a 50/50 allocation of stocks and bonds was actually successful 100% of the time.
He also found that over a 40-year period, the success rate of a 50/50 portfolio fell to 86%, but only fell to 92% with an allocation of 75% stocks and 25% bonds. With a withdrawal rate of 3%, the success rate for a 50/50 and 75/25 portfolio rose to 100%. Notably, he concludes, “We can generally observe that success rates increase for lower withdrawal rates, shorter time horizons, and higher stock allocations.”
What This Means for Your Investments
Using the 4% rule, we can determine roughly how much money one needs to accumulate in investments to retire. But it’s not only useful to people in their 60s and 70s. The 4% rule is popular in the financial independence community. Members of this community aim for their “FI Number” — their financial independence number — or the number they need to reach to achieve financial independence.
To calculate your FI number using the 4% rule, you can take your expenses and multiply them by 25 (because 1/25 is 0.04). So if you spend $40,000 in a year, the math is simple: $40,000 x 25 = $1,000,000. Under the 4% rule, you would need to accumulate $1,000,000 to retire, and you would be able to withdraw $40,000 every year, plus adjustments for inflation, until the end of your life.
Here are some other examples to help you visualize:
$60,000 x 25 = $1,500,000
$80,000 x 25 = $2,000,000
$100,000 x 25 = $2,500,000
This simple math is what empowers people in the financial independence, retire early (FIRE) movement to cut their spending, increase their savings and quit their jobs to retire early.
Anyone planning for their retirement should understand the 4% rule. But it’s not without controversy. While a person who retires at 65 might expect to live for as many as 30 years, what if they live longer? Or what about those who retire early and may need to live off their investments for longer periods of 40, 50 years or more?
Which brings up another important question: Does the 4% rule actually hold up? I’ll explore that next week in part 2.