Hello everybody! I’m back from a fun and exhausting vacation wherein I ate too much, slept not enough, and of course developed a sore throat and cough from either laughing and singing too much, or maybe it’s actually just a cold. Either way, my internal clock is all kinds of screwy and I didn’t realize what day it was yesterday until mid-afternoon. That’s why you are seeing this Finance Friday post on, well…Saturday.
I have no regrets. It was a great trip.
Anyway, you may have noticed over the last few months that I’ve mentioned the “4% rule,” net worth and its relationship to your retirement income, and “safe withdrawal rate” a number of times. I’ve been building towards a couple of posts that are going to discuss these concepts in depth. Most importantly, I want to discuss how people are confused by these concepts and focusing on the wrong things.
But before I do that, I wanted to prepare you by making sure you understand the underlying principles of the 4% rule. So I’ll quickly introduce the topic here, then I’m going to link to a number of other articles that you can read if you want more information.
Sound good? Let’s get started.
What Is The 4% Rule?
In very basic terms, the 4% rule is a rule of thumb that helps you figure out how much money you need to retire safely. How? Because the 4% rule is based on a study…or really multiple studies…that say you can safely withdraw 4% of your investment portfolio during your first year of retirement, then adjust for inflation every year after that. If you meet your income needs using 4% of your portfolio in year one, you have a high likelihood of being able to fund your retirement for 30 years or more. That makes 4% a “safe withdrawal rate” or SWR.
The rule is based on a study of investment returns over a 50-year period. A financial advisor named William Bengen decided to test the old common withdrawal rate of 5%, and found that that plan sometimes failed due to down markets. However, a 4% SWR worked in every case for at least 30 years. Since he published his work in 1994, and his results were further reinforced in a 1998 paper known as the Trinity Study, the 4% rule has been accepted as virtual fact by many retirement planners and retirees.
The opposite side of the 4% rule coin is that you need 25 times your expenses (100% divided by 4% is 25) in order to meet the 4% rule. So take your projected expenses in retirement, multiply by 25, and that’s your goal.
Why is that important to you? Because it gives you a concrete goal for your retirement portfolio. Once you reach that amount, you are statistically safe to retire. Whether or not you actually retire is, of course, up to you. But it means you can retire. It also means you are financially independent. Congratulations!
The Problem With The 4% Rule
I’m not a researcher, and I’m not going to dare to question those that have spent countless hours studying this topic. I have neither the time nor the interest to study millions of data points to see if it checks out.
But I am interested in looking at whether there is more to the story. Whether it is really as simple as “I need 25 times my expenses in an investment portfolio.” I think people tend to stop there without thinking through the entire retirement picture. In fact, I know they do, because I see comments that indicate that in online forums all.the.time.
So that’s what I plan to address in the next few posts. I’m going to address how you should calculate the income you need in retirement. And whether the 4% rule needs to address all of those expenses, or not. I’m going to look at what you should include in your investment portfolio when you are figuring out if it meets the 4% rule. I also want to look at whether a different SWR might be right for you.
In the meantime, the links below will get you a little more familiar with William Bengen, the 4% rule, the Trinity Study, and how they’ve held up over time. Check them out if you can.
Oh yeah…if you see 4.5% listed instead of 4%…we’ll get to that!
Further Research
- Wikipedia: Trinity Study
- Investopedia: Four Percent Rule
- Bogleheads: Safe Withdrawal Rates
- Money: The Right Way To Think About The 4% Rule For Retirement Income
- Michael Kitces: What Returns Are Safe Withdrawal Rates REALLY Based Upon?
How many of you plan to use the 4% rule for your retirement? If you are planning to use another number – what is it?
Gentle Reminder: I am not a financial advisor. I have never been a financial advisor. I will probably never be a financial advisor. I like talking about money. You should probably talk about money with a financial advisor before taking advice from someone on the internet.
I’ve written about this on my blog just a couple of weeks ago.
As a person who is scared of Numerals and the Mathematics, the 4% Rule is a great, easy-to-understand gateway into retirement planning. I think it’s a wonderful place to START planning for retirement, especially if you’ve got time before you want/need to pull the pin. But as you get closer, I think there should be a lot more financial fine-tuning going on.
In my own family I’ve seen one grandparent outlive his money, while another grandparent was financially comfortable for all of her days.
I know which one I’d rather be…
Yes, exactly! It’s a great way to set a goal, but then as you learn more you should refine your understanding.