Does the 4 percent rule for FIRE work with the S&P500?

Does the 4 percent rule for FIRE work with the S&P500?

The 4 percent rule for Financial Independence and Early Retirement (FIRE) is based on the performance of the US stock market (S&P500) since 1928, over a series of 30-year horizons. But has it worked in recent years since the research was published? And does it work for a non-US investor, who has to deal with withholding taxes and exchange rate risk?

It turns out that your mileage may vary, by quite a lot. The 4 percent rule did not work so well for investors in the 2000s, but did for investors in the 1990s and 2010s. And exchange rate risk reduces the effectiveness by a lot, much more than withholding taxes for the non-US investor! So, no matter how well a particular foreign market has performed in the past, always diversify your risk. Especially in retirement, when you have no chance to earn your way back into a sustainable position.


The 4 percent rule for Financial Independence is one of the key tenets of the FIRE movement. It is used to determine how much one can live on once they have accumulated enough investments. The origins of the 4 percent rule lie in a paper by William Bengen in 1994, where he looks at the returns on portfolios of US stocks and bonds starting from 1928 (right before the Great Depression) to see if a withdrawal rule which ensures retirees do not outlive their funds over 25 to 30 years exists. Bengen shows that an initial 4% withdrawal rate from the retiree’s portfolio, increasing for inflation every year, meets this criteria, provided 50% to 75% of the portfolio is in stocks.

In this blog, we have looked at how this rule is supposed to work, what can make it fail, and whether it applies to our local context:

A couple of oddities did stand out when doing all this research into the 4 percent rule and FIRE:

  • While the idea for the 4 percent rule had come about in the 1990s, most of what we read of the American FIRE movement are written by Gen-Xers and Millennials – where are the Boomers?
  • We now have access to much more than just investing in the Straits Times Index (STI) – is it easier to FIRE by investing in the S&P500 than in the perpetual laggard of the STI?

Let’s see if we can find some answers to those questions here!

How has the S&P 500 performed in the last 25 years?

As Bengen’s initial work on the 4 percent rule was published in 1994, it means that he only had data until 1993 or thereabouts to test his claim. How has the S&P500 stock index of the largest US stocks fared since then? In the chart below, we use the popular exchange traded fund, SPY, to show that over the next 27 years from 1993 to 2020, the S&P500 has had two decade long bull runs (in the late 1990s and 2010s). At the same time, there has been a period in the 2000s (after the NASDAQ crash and 9/11 attack on New York) where it did not really go anywhere. But over the entire period, dividends have been paid regularly, and in fact account for a lot of the return on the S&P500.

S&P 500 500 ETF (SPY) prices and dividends 1993 – 2020
S&P 500 500 ETF (SPY) prices and dividends 1993 - 2020

More importantly, how would a retiree, taking on Bengen’s advice to use a 4 percent withdrawal rate, but ignoring the advice on keeping about 25% of the portfolio in bonds, fare over the same period? We show this in the chart below:

Portfolio value and withdrawals of the SPY ETF for a USD investor in the S&P 500 1993-2020
Portfolio value and withdrawals of the SPY ETF for a USD investor in the S&P 500 1993-2020

Bengen’s advice clearly paid off for the retiree over this period 1993 to 2020. Even as the withdrawals grew with a long term inflation rate of 2% from $3,333 a month in 1993 to almost $6,000 a month in 2020 , the portfolio value also grew from $1 million to $5.6 million, even after the recent market crash! It appears that an investment in the S&P500 stock index in 1993 turned out to be a perpetual money machine!

To be fair, we did not account for taxes in the results above, as it is likely that US retirees with less than $1 million invested in the S&P500 index, and no other source of income, pay a 0% tax rate on their dividends and capital gains. But did Bengen’s advice pay off for a retiree on the other side of the world in Singapore, subject to exchange rate fluctuations and withholding taxes of 30% on dividends? Over this 27 year period, the USD/SGD exchange rate has been fairly volatile, as we show below, ranging between $1.20 to more than $1.80:

USD/SGD exchange rate 1993-2020
USD/SGD exchange rate 1993-2020

What have been the net effects of the exchange rate fluctuations and withholding taxes for the Singapore retiree investing in the S&P500 and hoping to live off the the returns using the 4 percent rule? We show this next:

Portfolio value and withdrawals of the SPY ETF for a SGD investor in the S&P 500 1993-2020
Portfolio value and withdrawals of the SPY ETF for a SGD investor in the S&P 500 1993-2020

The results are similar, although less spectacular. The holdings in SPY are able to meet the increasing monthly withdrawal amounts easily, although the portfolio value does not gain by as much, rising only to $3.6 million. Even if our intrepid Singapore investor invested in the S&P500 ETFs domiciled in Ireland with a withholding tax of 15% (and which were not available back in 1993), the portfolio value in 2020 only goes up a little to $4 million. The big gap between the USD investor and the SGD investor in the S&P 500 over 1993 to 2020 of some $2 million has been due to the impact of the USD/SGD exchange rate!

So our first takeaway about the S&P 500 and its suitability as a retirement investment is:

Be careful when investing in non-home currency investments. Exchange rate risk can take away half of your investment!

And it is not something that is easy to hedge as well. While you can certainly maintain a short USD/SGD position of $1 million or more over 27 years, it will require you to maintain a margin of of 5% to 10% of that notional amount in cash – cash which might be better off invested in stocks or bonds!

What about the people who retired in 2001 with S&P500 in their portfolios?

So investing in the S&P500 has been fantastic for the people who took Bengen’s advice back in the 1990s. Assuming these retirees were in their 60s in the 1990s, there are probably very few of them around today, which means that their kids, and the causes they supported, are the current beneficiaries of the huge run up in the S&P 500 over the last decade. But what about the boomers who retired a decade later? We don’t hear very much from them on their FIRE journey, if at all.

The fate of this missing retiree generation becomes clearer when we look at how the 4 percent rule fared in the 2000s. We show this below:

Portfolio value and withdrawals of the SPY ETF for a USD investor in the S&P500 2001-2020
Portfolio value and withdrawals of the SPY ETF for a USD investor in the S&P 500 1993-2020

This is quite a different picture from the picture for the 1993 retirees isn’t it? Instead of seeing the value of their investment in the S&P500 triple in value over 20 years, the 2001 retirees have seen the value of their portfolios fall to only 63% of the original value. Fortunately, this is still enough to ensure that they can withdraw according to the 4 percent rule adjusted for inflation of 2% per year so far, but they would be well advised to shift their investments into bonds for the next 10 years to ensure the viability of the withdrawals.

Hence the 2000s are a period when the Sequence of Returns Risk, or Sequence Risk for short, really bites back with a vengeance. The two market downturns following the 2000 NASDAQ crash and subsequent 9/11 attack on New York, and the 2008 Global Financial Crisis took out so much from the value of the portfolio, forcing the retirees to sell at the lows for their withdrawals, that even the tremendous bull market of the 2010s has not been able to make up for.

The picture looks even worse for the retiree in Singapore invested in the S&P500. We show this below:

Portfolio value and withdrawals of the SPY ETF for a SGD investor in the S&P500 2001-2020
Portfolio value and withdrawals of the SPY ETF for a SGD investor in the S&P 500 1993-2020

Due to the strengthening of the SGD in this period, the Singapore retiree would have seen the investment in the S&P500 drop to only 8% of the initial value! Even if the current downturn turns around into a bull market tomorrow, in all likelihood, the portfolio will run out of money next year, or the year after.

In the 1993 to 2020 period, exchange rate risk reduced the gains to the Singapore S&P500 investor by half. In the 2001 to 2020 period, the combination of Sequence of Returns Risk, and exchange rate risk literally wipes out the investor!

Interestingly, the Singapore investor might have done better by investing in the much maligned local stock market instead. The Straits Times index (STI) has not gotten much love from investors in recent years, because after peaking in 2007, it has not come close to the same level for the last 13 years. But it does pay a good dividend, which helps to protect against Sequence of Returns Risk (see here).

STI ETF (ES3) prices and dividends 2001 – 2020
STI ETF (ES3) prices and dividends 2001 - 2020

However, despite the downturns due to SARS in 2003, the Global Financial Crisis in 2008 and COVID-19 in 2020, an investment in the STI ETF has maintained 100% of its value since 2001, even as the withdrawals have increased over time for inflation.

Portfolio value and withdrawals of the STI ETF (ES3) for a SGD investor 2001-2020
Portfolio value and withdrawals of the STI ETF (ES3) for a SGD investor 2001-2020

Note that the STI ETF has existed only since 2002. The data for 2001 is extrapolated from the correlation with the STI, and assuming dividends in 2001 are the same as in 2002.

So, our second takeaway from this is:

Never put all your (retirement) eggs in the same (foreign) asset basket. Diversify your sequence of returns & exchange rate risk by investing across home & foreign countries

How have the Millennials fared from 2009 to 2020?

As noted previously, much of the writing about the FIRE movement in the USA have been from people who have retired since 2009. Looking at how the S&P500 performed since the Global Financial Crisis, we would expect that these Millennials have had an easier time with managing their investments and withdrawals compared with the Boomers who came before them. And this is borne out when we look at the how the 4 percent rule has fared for them:

Portfolio value and withdrawals of the SPY ETF for a USD investor in the S&P500 2009-2020
Portfolio value and withdrawals of the SPY ETF for a USD investor in the S&P 500 2009-2020

Despite the recent crash in the S&P500 (our data runs to 20 April 2020), the portfolio value for these Millennials has risen over the past 10 years, growing an investment of $1 million in 2009 into a portfolio worth more than $3 million. This level of assets basically guarantees that they will never run out of money as long as they stick to the withdrawal rule.

What about an investor in the S&P500 based in Singapore? Well, the USD/SGD exchange rate has largely hovered at around the same level since 2009. Hence, the impact of exchange rate risk during this period has been much less than in the previous decade.

Portfolio value and withdrawals of the SPY ETF for a SGD investor in the S&P500 2009-2020
Portfolio value and withdrawals of the SPY ETF for a SGD investor in the S&P 500 2009-2020

The movements of the USD/SGD exchange rate over the past decade have only taken about $250,000 off the value of the portfolio for a SGD investor as compared to a USD one. So investing in the S&P500 over the past decade probably has been a good decision for the retiree in Singapore. This is more so, once we compare it against investing in the STI:

Portfolio value and withdrawals of the STI ETF (ES3) for a SGD investor 2009-2020
Portfolio value and withdrawals of the STI ETF (ES3) for a SGD investor 2009-2020

An investment in the STI back in 2009, and following the 4 percent rule, leaves the investor with a portfolio worth only around $1.5 million, or about half the value compared to investing in the S&P500. Having said that, an investment which has grown by 50% over the past 10 years, despite the STI going back to levels not seen since 2010, all the while withdrawing according to the 4% rule, makes the STI a very resilient investment!

As the 2009-2020 period is too short, there is not a lot we can conclude from this period, except:

Be careful about putting all your investments into the S&P500. If history is any guide, there is no guarantee that the returns in the next decade will be same as the past 10 years

Concluding thoughts

We started off this blogpost wondering why most of the bloggers extolling FIRE and investing in the S&P500 have been Millennials who FIREd post-2009, and why we hear so little about it from those who might have FIREd earlier, before 2008. And the truth is that successful FIRE depends to a large extent on your timing.

The unfortunate Boomers who retired in 2000s with most of their investments in the US stock markets have seen a gradual erosion of their nest egg, to a degree where it is uncertain whether they can get through another 10 years of retirement without calling upon other sources of income, like Social Security. Of course, there is no such luck for the Singapore retirees who put most of their money into the S&P500 in the 2000s. The strength of the SGD against the USD has ensured that that nest egg has almost vanished completely!

For ourselves the lessons we draw form this are threefold:

  1. Be careful when investing in non-home currency investments. Exchange rate risk can take away half of your investment over time
  2. Never put all your (retirement) eggs in the same (foreign) asset basket. Diversify your sequence of returns & exchange rate risk by investing across home & foreign countries
  3. Be careful about putting all your investments into the S&P 500. If history is any guide, there is no guarantee returns in the next decade will be same as the past decade

What do you conclude from this analysis?

In our next post, we look at methods which have been suggested for overcoming the sequence risk of the S&P500 in the 2000’s. Keep an eye out for it!

References

Bengen, W. P. (1994) “Determining Withdrawal Rates Using Historical Data.” Journal of Financial Planning 7, 4 (October): 171–180

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