What is the 4% rule? Or (How much do you need to retire?)

The more I think about it, the more I realise this should have been an earlier post. However, after doing my first reader case (https://intristang.com/reader-case-1/), it can wait no longer.

The goal of this article is twofold: 1) give you a very big-picture view of the 4% rule/safe withdrawal rate; 2) pique your curiosity for additional reading/research. There will be many caveats and different scenarios, and this post is not meant to address them all. I’ll also do my best to be as neutral as possible in being for and against the 4% rule.

What is the 4% rule?

The 4% rule is actually the answer to a question. The question being: how much do I need to retire? 

In the late 90’s three finance professors from Trinity University attempted to determine “safe withdrawal rates” from retirement portfolios. What they considered a success or safe was if the retiree did not run out of money during their retirement. 

What they found was a 4% annual withdrawal rate (adjusted for inflation each year) almost never resulted in a retiree running out of money. E.g.: if you have a $1M retirement portfolio/net worth, you can “safely” withdraw $40,000 (or 4%) each year and adjust for inflation over time.

Here’s a link to the study and tables based on withdrawal rates, time periods, and portfolio allocations: https://www.aaii.com/files/pdf/6794_retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable.pdf

The 4% rule is, however, not a guarantee but more a rule of thumb. 

tl;dr: As a major rule of thumb, if you want to project how much you need to retire, divide your annual expenses by .04 (or multiple by 25). E.g.: annual living expenses of $30,000 would result in $750,000 to retire via the 4% rule  

My aha moment with FIRE and the 4% rule

The great part of the 4% rule is its simplicity. The massive problem with the 4% rule is that if we use our annual expenses while we are working it probably generates a massive number. 

$750,000 as a goal for FIRE sounds attainable, but how many people are only spending $30,000 per year? For many to most folks in the Bay Area, $30,000 per year might not even cover rent. 

My aha moment with FIRE came a few years ago when I was reading a FIRE blog about the 4% rule. The author was saying they’d need $1M to withdraw $40,000 safely per year. “Okay,” I thought, “a million dollars isn’t impossible” (and it’s certainly a lot lower than the ~$5M I most frequently hear people say they need to retire). 

As I kept reading, I realised the $1M they referred to wasn’t per person but per couple. They “only” needed $500k each. BOOM! FIRE goal cut in half. Then I realised something else: this couple was Canadian. “Why does that matter?” you might think. Well, their $1M couple goal wasn’t a million dollars, it was a million Canadian dollars. At the time of writing, 1 USD = 1.3 CAD, so that $1M that became $500k was now $384,615.39.

Okay, that sounds great and all, but that also means their $40k per year is really ~$30,000 per year. Didn’t we just agree that $30,000 wouldn’t even cover rent in the Bay Area for the year? 

Right! The final piece is projecting your annual expenses after you’re done working. That means you don’t have to live in an expensive city and pay crazy rent. For me, reading that this couple could live on $30k per year made me feel like there’s no reason I can’t either. Hopefully through my cost of living posts (https://intristang.com/tags/cost-of-living/), I can show that you can live a great life for less than you think. 

Trinity Study & Assumptions for the 4% rule

Obviously there were (and are) a lot of assumptions for their study and for this rule. I’ll do my best to summarize the assumptions (but am fairly certain there are things I will miss). 

The first assumption is that the calculated safe withdrawal rates were for portfolios with the following allocations: 100% stocks, 75% stocks/25% bonds, 50% stocks/50% bonds, 25% stocks/75% bonds, and 100% bonds.

Read also: https://intristang.com/investing-101/

The second assumption was calculating safe withdrawal rates for payout periods no more than 30 years: 15, 20, 25, and 30 years. If we are hoping to retire early, say in our 30s or 40s–and we want to live past 60 or 70–isn’t a 30 year payout period too short? I’ll address this in “Variations to the 4% rule” below. 

The third assumption or maybe more of a fact about the dataset is that they used stock and bond performance from 1926 to 1995. Two quick red flags here: 1) this dataset doesn’t include the dotcom bubble of ~98-02 or the 2008 recession (it does include the Great Depression and a lot of other bad times); 2) bond performance/yields were way higher back then than now. I would assume most of the portfolio allocation with anything above 25% bonds would not work today. 

Sequence of Return Risk

So far we’ve painted the picture of what the 4% rule is, how it came to be, and some assumptions it is based/built upon. Now I want to shift gears to some potential issues/holes with said rule.

The largest gap/issue folks (even proponents of the rule) have with the 4% rule or safe withdrawal rates in general is sequence of returns risk. 

If we assume the historic/average rate of return of the stock market or S&P is anywhere from 6-10% and we are only going to pull 4% per year, that looks like our portfolio will actually consistently grow (e.g. 6-4=2). The problem however is that those are averages.

It turns out timing and order can really throw a wrench into retirement. What if the year immediately following our retirement the stock market plunges 50%. If we had $1M and we lost half of our portfolio’s value, we are now at $500k. When it comes time to do our annual withdrawal, 4% of $500k is only $20,000. 

We can withdraw more under this circumstance, but the issue is you want to do your best to not withdraw money when your portfolio has recently taken a massive hit. The reason: you want your money in your portfolio to recover its losses. If/when we withdraw that money as cash, it has zero chance to recover any of its losses. 

It turns out, the first decade matters most when analyzing the sequence of returns risk. After analyzing the correlation between safe withdrawal rates and 1-year return, 10-year nominal return, 30-year real return, and 10-year real return, it was concluded that the 10-year real return had the highest correlation or predictive trend (click here if you’d like to read further into said analysis).

tl;dr: when it comes to retirement timing and order of returns trumps averages; the first ten years of retirement matter most: if you make it through your first decade, you are probably good to go. If not, trouble could be waiting ahead.  

Skeptics and problems with the 4% rule

We have covered some assumptions that make the rule work and addressed its largest obstacle: sequence of returns. Now I want to change gears and share some views of skeptics and some of the problems they have brought to light. 

Financial Samurai & “the 1% rule” 

The first skeptic I want to bring up is Financial Samurai. He’s probably one of the biggest personal finance bloggers out there and is a huge dissident of the 4% rule. He advocates for a safe withdrawal rate closer to 1%. The big reason: “risk free rate” or 10-year treasury yields have drastically fallen in the last decade. His formula for safe withdrawal rate is the following: 10-year bond yield x 80%. Today, that’d get you ~1%. 

Read more here: https://www.financialsamurai.com/proper-safe-withdrawal-rate/

In my opinion, this view is on the hyper-conservative side. Financial Samurai is quite different from most FIRE folks in that he came from an investment banker background. He made a ton of money and has a massive portfolio compared to most folks, so it’s a lot easier for him to advocate 1%.

The problem with this view is that it basically ruins FIRE for most people. If I tell you to aim for aggregating a $1M retirement portfolio and all of a sudden that number jumps to $4M, you’re probably going to give up on trying to retire early.  

Big ERN & “the it depends rule” 

The other large dissident toward the 4% rule is Big ERN. He is the author of the Safe Withdrawal Rate Series (https://earlyretirementnow.com/safe-withdrawal-rate-series/). He is more conservative than most FIRE folks but nowhere near as conservative as FS. 

His “rule” is based much more on looking at people’s specific scenarios as well as the investment environment at time of desired retirement. Here’s an excellent article of his highlighting 10 things the 4% rule doesn’t want you to know: https://earlyretirementnow.com/2018/06/27/ten-things-the-makers-of-the-4-rule-dont-want-you-to-know/

While I do encourage you to read some of his articles, I am fairly confident many of you are probably too busy (or uninterested, lol) to dig deeper. From my reading of his series and articles (among other folks’ analyses) it seems like reducing your SWR from 4% to something like 3-3.5% drastically increases your odds of success (not running out of $ in retirement). 

Variations to the 4% rule

With the 4% rule standing the test of time (sort of) it was only a matter of time until folks wanted to put their spin on said rule.

The 1% rule

Covered above under skeptics/FS, but we can view this as the most conservative variation. As long as the risk free rate or 10-year treasury yield is ~1.2% we can view it as the 1% rule (80% x 10-year yield).

The 3.5% rule

A lot of folks who do extra analysis tend to end up here. As we mentioned above, the Trinity study assumed no more than a 30-year horizon of payment withdrawals–that’s a problem for early retirees (or at least those that kind of want to live long). 

“[I]ncreasing a time horizon from 30 years out to 45 years reduced the safe withdrawal rate from 4.1% down to 3.5%…it appears that the safe withdrawal rate does not decline further as the time horizon extends beyond 40-45 years (given the limited research available); the 3.5% effectively forms a safe withdrawal rate floor, at least given the (US) data we have available” (https://www.kitces.com/blog/adjusting-safe-withdrawal-rates-to-the-retirees-time-horizon/).

The reason for the above actually comes back to Sequence of Returns Risk. It turns out that reducing ~4% to 3.5% was enough to get through the first decade safely, and once you get through that first decade you’re “in the clear” so to speak. 

The 3% rule

Besides FS, this is the most conservative I have seen anyone go. If you refer back to the Trinity Study (https://www.aaii.com/files/pdf/6794_retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable.pdf), you will notice that when they reduce their SWR to 3% their success rate was 100% across all portfolios. 

IIRC, browsing through 30ish of Big ERN’s SWR Series, I don’t think he ever recommended below 3.25% as a SWR and if he did it wouldn’t have been lower than 3%. 

If you want to err on the side of conservatism without going full-blown FS, I don’t hate recommending 3% instead of 4%. However you’ll quickly notice that 1% makes a huge difference on your FIRE number. E.g.: if you need $40k/year in reFIREment, that is $1,333,333.33 using 3% vs $1M using 4%. 

The 4.5%, 5%, or more rule(s)

The creator of the 4% rule himself Bill Bengen has actually revised his initial rule and is now comfortable with 5% (https://www.marketwatch.com/story/the-inventor-of-the-4-rule-just-changed-it-11603380557). He even calls 4.5% the “worst-case” scenario. The reason for this is more recent, strong annual stock performance. 

If you’re more of a watcher than reader, here’s Graham Stephan’s take on the 4% rule. He covers the origin of the rule and new variations anywhere from 3-6% SWRs based on your retirement length (<=30 year or 30+ years) and how flexible you’re willing to be. 

https://www.youtube.com/watch?v=GaHrHTELJ2A

Final thoughts & recap 

Today we tried to answer: how much do you need to retire? 

We did that by providing the background of three finance professors in Ireland trying to answer that same question. Their answer was the 4% rule. While the 4% rule is far from perfect, it gives us a good, high-level foundation.

Based on the changing of times/circumstances and skeptics, we now have some new and different variations on the classic 4% rule (anywhere from 1-6ish %).

In my opinion, I think 4% is fine to use (if you want to be conservative, use 4% and 3.5%). While inflation continues to be scary, earnings/the stock market have been very robust and resilient the past few years. Additionally, early retirees have a lot more flexibility than typical retirees of the past (and present?). 

This flexibility lends FIRE-ees to be able to continue freelance working/consulting during their reFIREment and leveraging geoarbitrage to move/live somewhere cheaper. Regardless of what value/SWR you use, I highly recommend getting aggressive (and creative!) with your forecasted annual expenses. 

If you enjoyed this article (or are skeptical), please leave me some feedback and/or comments. If you’d like to stay in the loop and never miss a new post, please subscribe below. Lastly, you can play around with hypothetical FIRE values here: https://www.firecalc.com/