The 4% rule to FIRE!

The 4% rule or the Safety Withdrawal Rule (SWR) is often used in the Financial Independence Retire Early (FIRE) community.

It is a more a rule of thumb rather than a fixed rule, but one that many are using to have a clear number of the amount they would need to reach Financial Independence. In this post I will go through this “rule” in a bit more detail, where it origins from as well as some of the pros and cons.

Summary of the 4% rule

The 4% rule is just stating that if the history of the financial markets in the US were to be an indication of the future, one could be withdrawing 4% over 30 years according to the Trinity Study (the origin of the Safety Withdrawal Rule / The 4% rule).

How much one would need is individual but let’s say it is 20,000 USD per year (annual expenses), then one would need 20,000/0.04 = 500,000 USD. Once you have 500,000 USD you should (according to this rule) be able to withdraw 4% every year after inflation for at least 30 years and not run out of money.

This is of course a very simplistic view but that is also why it is so compelling to the FIRE community. By using this as a rule of thumb, anyone can have a clear financial goal and know when one has reached Financial Independence (FI). One very important thing to remember is that this study was based on the assumption that the money should last for at least 30 years, most of us want it to last for 50 years or more and that has implications!

Just be aware that this study was done based on historical values when interest rates were closer to 10% and now they are much, much lower. So getting these returns will be significantly harder which most likely means more risks has to be taken. Still there is nothing saying you have to get 4% return via the financial market. They key thing is that you do the calculation based on the return you think you are able to achieve and that is based on how you invest your money.

The background and origin of the 4% rule

The 4% withdrawal rule or just the 4% rule or the Safety Withdrawal Rule (SWR) is often used as a benchmark for how much money you need to be able to retire.

The first public study was done out of the Trinity University (sometimes just referred to as the Trinity study) and published in 1998 (click here for a summary). The idea of the authors was to figure out a sustainable withdrawal rate for retirement periods of between 15 – 30 years. The authors looked at the US stock market (S&P500) and long-term corporate bonds between 1926 – 1995 and a variety of different portfolio compositions to see how they would fare over time given this historical data (remember that historical data never is a true guide or indication of the future).

They did not take any transaction costs, fund management fees nor taxes into consideration, which means that anyone looking to use this rule of course should take that into account. A low-cost and tax efficient investment is absolute key in being successful without having to spend loads of time on one’s investments.

Below is a table of their results (after inflation has been taken into account) and for different portfolio allocation, withdrawal periods and rates:

If you look at the 4% withdrawal rate over 30 years, you can see that for portfolios consisting of at least 50% stocks, the success rate has been very high, ranging from 95 – 98%. This means that almost regardless of when in time you started you withdrawals, if you withdrew 4% or less, your money would last you at least 30 years.

Another interesting table to look at is how much money one would have left after withdrawing these 4% every year over 30 years. Most FIRE aspirants of course intend to retire early and hence will need the money to last much longer than 30 years. The common idea there is that if they last for 30 years, adding more years will just change the numbers marginally but one should be aware as depending on when one retires in the stock market cycle will have a significant impact on how long the money will last for. Most people will (naturally) reach FI during bull markets and at the peak of the market and if the market then falls significantly and one persistently withdraw the same dollar value (what used to be 4%), it can deplete the assets quite fast….At the same time, later on in life, one tends to need less money(fewer expenses unless health care is needed) so there are different factors impacting the number of years the investments will last.

The value of your portfolio after your withdrawals:

In the above table, they have not taken inflation into account and that is why I guess we don’t see a zero value on the 4% withdrawal level after 30 years for any of the portfolios. These numbers are based on 1 MUSD and if we look at the stock portfolio, the terminal value would have differed between 1,5 MUSD and 16,9 MUSD. So it is easy to see that the “timing” makes a massive difference as to how much is still available after 30 years. This might also be one reason why some use this 4% rule, they just disregard inflation (as well as transaction costs and tax) and then this historical study shows that you would be able to withdraw 4% of your assets for the rest of your life!

Even if this study solely considers the financial markets, your money doesn’t have to be invested in the financial markets to make this happen, any investments where you can get these returns will of course do. Maybe you can even get these return or better but with less volatility than one can experience in the stock market, for example via rental properties.

A big reminder here is that all these numbers are historical and based on the US. Other regions would have different numbers and they are for sure not a guarantee for the future, still, many seem to be using this as a rule of thumb as it is so simple to have a clear financial number for focus on.

How to apply and think about the 4% rule

The first step is just to figure out how much money you need every year. For inspiration check out my simple calculations in the post Playing with FIRE?

As an example: if you need 25,000 USD per year to cover all your expenses, you would need a total investment portfolio of 625,000 USD (25,000/0.04). When you have that amount, based on history and the above study, you should be able to withdraw 4% every year and the money should last you for at least 30 years (longer if we disregard inflation). One has to remember that this number must be after management fees, transaction costs, account fees, taxes and ideally of course also inflation.

Many FIRE advocates focus on this 4% rule to have a financial goal of exactly how much money they will need to be able to retire early. They decide how much money they need per month and year and then just do the numbers. Then they invest as much as they can of their income. The FIRE community tends to save a very big portion of their income, often more than 50% because they want to retire as soon as possible and this is a very clear and burning desire of theirs.

I would still ask you to think about the fact that what might look like “big number” even if you use the 4% rule, doesn’t have to be all that big. When you start your journey, you will learn about money and The Language of Money and it will serve you for the rest of your life. You will never worry about money ever again. You will train your mind to think about money and investments (ideally passive income) and you will become very creative in finding new ways of both saving and making more money.

As an example: If you say your number is 3,000 USD per month, you should aim for 900,000 USD (36,000/0.04) according to the 4% rule and it might feel like it will take forever and even longer!

What if: You find a partner or even a friend, who has the same goal which means you can lower your costs by 1,000 USD per month (you are now two people who can split some costs and encourage each other). Your number now is 600,000 USD.

Then you realize that as you are working, you are constantly adding to your pension pot (or your employer is). Even if you only work for another ten years, that pension will still pay you 500 USD per month from when you are 65 years (without making any assumptions about your current age). This means that you will need 500 USD less per month from when this can be paid out so I will leave it out for now, but don’t forget to take your pension savings into account!

You might also have a spare room that you can rent out (or even move to lower your accommodation cost significantly) for 500 USD per month. We assume this can be done in eternity and your number now is 450,000 USD.

You then figure that when you “retire” and have all your time at your own disposal, you will drive Uber (you love driving anyway) or whatever other useful interest you have that will make you 500 USD per month. Just because you want FIRE, it doesn’t mean you will do absolutely nothing once you retire. You will most likely find a Side Hustle to spend time on when you want to and you will still make money! So your number is now: 300,000 USD.

So my message for you by this example is to not get deterred by what initially seems like a large number! Break it down, tweak it and as you start your journey, the more ways you will find to make sure you reach it as fast as possible. If there is a will, there is a way and you just have to break it down into small steps as it for sure is doable for everyone!

Pros and cons with the 4% rule!

There are of course many pros and cons with this “rule” but personally I think one should be using it more as a guideline than a factual rule of what is going to happen in the future in the financial markets. Below are some of the points I believe one should consider and especially if one intend to be retired for longer than 30 years (like most of the FIRE community does).

Pros:

It is very easy to use and calculate a financial goal.
Investing broadly is more or less completely passive (buy broad cheap ETFs).
If you start working towards your financial goal, you will have to take control of your finances.
You will most likely live a happier life, not one of FOMO of FOPO.
You will find what is of importance in your life.
You will become creative to make the most of your money as you want your FI fast.
You will constantly look for and find new ways of generating more income (passive income, side hustles etc.).
You will understand and speak the Language of Money and hence get great value, low-cost and most likely never be tricked out of money.
Even if this rule won’t be exact to your life, I believe there are and will be very few FI people who will never make any more money in their entire lives again.
If you also become great at saving, you will be much more flexible, adaptive and creative than most so even if your number was not perfect, you will find a way.
More time available to you means that you can learn more, earn more and do more of the stuff you love!
If you are an engineer, why not do Monte Carlo simulations on what it could look like in the future and give a new view on at least the level of interest paid on corporate bonds.

Cons:

No one knows what the future returns of the financial markets will be like.
All the numbers in the Trinity Study (as well as new similar studies) are based on history.
They did not take fees of any sort into account.
They did not take taxes into account and most likely you will have to pay some taxes one way or another so one has to take that in to account.
Bonds used to yield around 5% or more and many are now down to 3% (or in that region for investment grade corporate bonds).
Current central banks interest rates (in the developed world) are extremely low and most experts believe that they will remain low as we are close to a downturn in the business cycle.
When you start to withdraw and the length of time you wish the money to last of is of importance to make sure you don’t run out of money.
Many people will reach FI during bull markets and then start withdrawing during the downturn and this can have a significant impact on the value and it can actually totally deplete the assets (Sequence of Return Risk).

Intending to retire young? – Additional considerations!

Since publishing the SWR, there have been numerous studies done on this topic but as far as I know, no one has spent so much time on the 4% rule for the FIRE community as www.earlyretirementnow.com. If you like numbers just as much as Karsten or just want to understand more about this rule and to what extent you can apply it and possibly how to tweak it to suit you, check out his site as it is truly amazing. He is running numbers in numerous ways dating all the way back from 1871 in order to make different simulations!

Among the most important conclusions he has drawn we find his statement that the 4% rule as a rule of thumb is good but he doesn’t find it conservative enough so he is rather using 3.25% or 3.50% when including social security.

One of the key aspects is that most FIRE aspirants want to know that they will not run out of money and ideally leave money behind as well. The money should potentially be used for 60 years and of course take inflation into account. This changes the scenario from the old “4% rule” and the below is copied from his site (link here):

“Lowering the withdrawal rate to 3.5% should improve the success rates, as we pointed out last week: at 100% equity share we had a 96% success probability preserving 50% of the final value after 60 years. That rate goes down to 88% when the CAPE ratio is between 20 and 30. Of course, for CAPE values below 20, the 100% equity portfolio had a 100% success rate, both over 30 and 60-year horizons. Nice to know, but again, today’s CAPE is at 27. For me personally, a 12% failure probability is still a bit too high.“

Today (Dec 2018) the CAPE is above 30 and what his studies are showing is that most people will likely reach their FI number at a bull market (normally high CAPE). So the challenge might be the fact that one retires with the idea of using the 4% rule, still having 100% equities and the market starts falling. If you intend to use the money for a very long period if time, it might mean trouble unless you are flexible with your withdrawals or have the possibility of adding more money.

The cool thing he has done is to look at how one could possibly handle this by using an equity glide path which basically means that you might have 100% equities when you reach FI but then bring it down to around 60% (to lower the risk of having full equity exposure when the market might be about to turn south). Then start to invest the 40% in stocks again but over a period of time. By doing this you are lowering the Sequence of Return Risk (basically bad timing of starting your withdrawals i.e when the markets are falling). He has a brilliant post on this topic and I recommend you to check out (find it here). He is doing numerous calculations here and in particular looking at 60 year withdrawal periods as well as periods with high CAPE (high equity valuations) versus low and the equity glide path seems to have quite a significant contribution!

I am not saying that you should throw the 4% rule out of the window but I am asking you to be cautious about how you apply it. Make sure you understand that this is just a guideline and not a given truth of what will happen in the future.

Food for thought

When you reach FI, ideally don’t start withdrawing from an equity only portfolio if you want it to last for >50 years. Lower the equity risk and then build it up again towards a high equity exposure but lower the Sequence risk early on and ideally keep making some money via your side hustle to create an even bigger buffer. Over the long run you want to have a higher equity exposure again as that is where you will get the returns, but the initial 5-10 years of you retiring are of importance so be a bit cautious during that period. If you happen to be very unlucky with your timing, adjust your costs or increase your income to compensate because making large withdrawals in falling markets can be devastating for the viability of your funds.

As long as you keep using your head I’m sure you will be FIRE proof, as you will be using your creativity when needed, either to make you more money or to use less. If you are smart about it, the 4% rule of thumb will work but if you want to be safer, add in a buffer of up to 1% (using a 3% rule instead) and by most if not any historical back tests of the US markets you would have been just fine.

Use “the 4% rule” as a rule of thumb, keep your costs down and find different ways of making your money work for you instead of solely relying upon the financial markets generating the return for you. The more you are in control, the better you will feel during your journey to FI!