The 4 percent rule for Financial Independence
We usually hear about the 4 percent rule in discussions on financial independence and retirement adequacy. How does it work? The idea is that we can start our retirement by withdrawing 4% of the value of our assets initially, and increasing this withdrawal amount (in dollars) by the rate of inflation every year thereafter. The 4% “safe withdrawal rule” is a rule of thumb to ensure that, even with no other sources of income, we will not outlive our retirement funds.
The origins of the 4 percent rule lie in a paper by William Bengen in 1994, where he examined the returns on portfolios of US stocks and bonds starting from 1928 (right before the Great Depression) to see if there was a withdrawal rule which would have ensured that retirees would not outlive their funds over a retirement period of 25 to 30 years. Bengen’s work show that an initial 4% withdrawal rate from the retiree’s portfolio, adjusted for inflation every year, meets this criteria, provided 50% to 75% of the portfolio was invested in stocks.
A Safe Withdrawal Rule is the percentage of the initial assets, as a dollar value, withdrawn from a portfolio of assets every year (adjusting for inflation), and which ensures that someone with no other income can rely on it for the next 30 years without running out of money.
Bengen’s work was later extended in the “Trinity” studies by Cooley, Hubbard and Walz in 1998, 1999 and 2011, where they show that the 4% initial withdrawal rule, adjusted for inflation, was still feasible over a 25 to 30 year retirement period, even after adding the data from the years after 1994 (which includes the 2001 and 2008 stock market crashes).
How exactly does the 4 percent rule work?
The 4 percent rule has become very popular with the FIRE (Financial Independence, Retire Early) movement, and has become the received wisdom that you can live indefinitely on the stream of income and divestments from a diversified portfolio of stocks and bonds. Put in another way, once you save 25 times your annual expenses, you are financially free forever.
There are, however, a number of misinterpretations about how the 4 percent rule for financial independence actually works. Here are some common ones:
- 4 percent of the current value of the portfolio of assets is sold or withdrawn every year to pay for living expenses. Sorry, no. As the assets are sold off over time to cover living expenses, the value of the portfolio may go down. If we used 4 percent of the value of assets, this means the amount we have to spend on living expenses goes down over time! This does not even cover inflation!
- 4 percent of the initial value of the portfolio of assets at the start of retirement is used to compute the amount which is sold or withdrawn every year to pay for living expenses. Closer, but no cigar yet. While the 4 percent rule is used to set the amount at the start of retirement, this dollar amount is adjusted every year to account for inflation. At a rate of inflation of 2% a year, prices roughly double every 30 to 35 years. To maintain the same standard of living, we need a dollar amount twice the initial amount at the end of retirement.
- If I withdraw 4 percent a year, my money only lasts for 25 years. Well, yes, only if you put your money under your pillow and not do anything about it. The idea is to make sure that your money stays invested, and earns more than inflation over time, so that it can last you to 30 years and possibly beyond.
- If I follow the 4 percent rule, my money will last me forever. Well, no, the 4 percent rule is not a guarantee. It is still possible that you will run out of money in 15 or 20 years time. The key is to manage your investments, withdrawals, and spending to maximize the chance that it will work out.
What the 4 percent rule means is, use 4% of the initial value of the portfolio of assets at the start of retirement to compute the amount to sell or withdraw every year to pay for living expenses. Adjust this initial dollar amount every year thereafter by the rate of inflation. The table below shows how this works for an initial portfolio of $1,000,000:
|Year of Retirement||Amount Withdrawn|
Pitfalls to the 4 percent rule
The 4 percent rule is not a guarantee, and at best, it works for a 30-year retirement horizon. For conservatism, a 3.5% rule (which is not so catchy sounding), or even a 3.25% rule is better. Those who plan on retiring early in their 30’s or 40’s will also need to adopt a more conservative rule. So, instead of retiring when we save 25 times our yearly expenses, it is safer to save 33 times expenses.
For conservatism, a 3.5% or 3.0% rule may work better over long retirement horizons
Here is one final pitfall many are not be aware of:
- My projections for stock returns are 5% to 7% a year in the future, and this will ensure that I can withdraw 4% or even 5% (inflation adjusted) forever. Be careful! We are now in a era of low interest rates, and this pulls down returns, as you definitely should not be 100% in stocks!. Also, the 5% to 7% returns in stocks will come with volatility. Volatility of 15% to 25% a year can drag down returns by 2% to 3% in the long term, so the actual stock market returns will be closer to 3% to 5% a year at best.
Bengen, W. P. (1994) “Determining Withdrawal Rates Using Historical Data.” Journal of Financial Planning 7, 4 (October): 171–180
Cooley, P. L., C. Hubbard, and D. Walz (1998) “Retirement Spending: Choosing a Sustainable Withdrawal Rate.” Journal of the American Association of Individual Investors 20, 2 (February): 16–21
Cooley, P. L., C. Hubbard, and D. Walz (1999) “Sustainable Withdrawal Rates from Your Retirement Portfolio.” Financial Counseling and Planning 10, 1: 39–47
Cooley, P. L., C. Hubbard, and D. Walz (2011) Portfolio Success Rates: Where to Draw the Line