What is the 4% Rule?
The 4% rule is a retirement withdrawal guideline that suggests one can safely withdraw up to 4% of a portfolio in the first year of retirement and steadily increase the amount with CPI for up to 30 years without exhausting the balance.
“Do I have enough to retire?”
I’m not sure there is a more popular question in all of personal finance. Come to think of it, there may not be a more important one either; at least in terms of retirement planning.
Frankly, we can’t know exactly how much we’ll need because none of us can see the future, but there is a very popular rule of thumb that can provide a quick sanity check.
The Trinity Study
In 1998, three professors from Trinity University wrote a paper about research they had conducted which was focused on determining safe withdrawal rates for retirees.
One of the methods they investigated was called “The 4% Rule”.
It more or less stated that, based on historical data, investors with a portfolio holding a mix of stocks and bonds who began withdrawing at the rate of 3% to 4% annually (increasing with CPI thereafter) were “extremely unlikely” to exhaust the funds in the portfolio within a 30 year period.
In other words, if you begin withdrawing 3%-4% of your retirement portfolio and increase withdrawals to keep pace with CPI, you probably won’t run out of money before you die.
Of course, the authors also noted that the stock market is unpredictable and that “corrections likely will be required” as one navigates up and down years in the markets.
To be clear, it was always meant to be a guideline or rule of thumb and never to be assumed as a hard and fast, 100% reliable financial law.
We’ll elaborate on this more below.
But 4% of What?
If you read the previous paragraph, and somewhere in the middle of it you stopped to run some numbers for yourself, you would have had to address a very important question.
But how big of a portfolio do I need in order for a 4% withdrawal rate to be enough to provide a suitable standard of living?
After all 4% of $10MM is $400,000, but 4% of $10 is a quarter, a dime, and a nickel. Good luck retiring on that, even if it never runs out.
So, 4% is a good start, but it’s not much help until you know how much you want to spend in retirement.
So, how much do you want to spend in retirement?
This too, is a challenging question to answer with much accuracy.
I prefer to think of retirement in three levels of spending. In the first, money is hardly an object. We can travel at will, eat out at will, the house is paid for, and we have no significant obligations on our portfolio.
Scenario two is a comfortable retirement with pieces of the first plan, but a need to keep an eye on spending more carefully. In this forecast, I see a standard of living similar to the one I am in now as an earner.
Finally, the last scenario is a retirement where money is tight and spending minimal. Social security income is critical to survival in this plan and I will likely work up to 70 or even longer.
Personally, I’ve made a budget for option one and I’m aiming for it with all I’ve got.
As you make your own forecasts, don’t forget to consider whether or not you will have a paid off home, any traveling plans you have, charitable goals, etc.
Then, add a little more cushion in case you forgot something. After all, it will be easier to spend your excess than find more of what you don’t already have saved.
A Shortcut: 4% Equals 1/25th
Another way to do the math is to multiply your expected annual expenses by 25.
The reciprocal of 1/25th is 25, so this just cuts out a step and gives you the portfolio balance you’re trying to calculate a little more quickly.
For example, if you estimate that you’ll need $100,000 each year in retirement to cover your expenses, 25x quickly provides you with a nest egg goal of $2.5MM (of which $100k is 4%).
It’s a small tip, but I have an easier time multiplying by 25 than I do dividing by 0.04.
21st Century Adjustments
There’s one very important characteristic about the Trinity Study I feel inclined to point out.
First, when it was written, life expectancies were a little shorter. At the time a 30-year retirement was probably a normal, if not conservative, forecast for a retirement duration.
These days retirements can run even longer on average.
As a result, you may want to adopt the 3% rule and multiply those expected expenses by 33.3 instead of 25.
The importance of an adjustment increases for those of you who seek to F.I.R.E. (Financial Independence Retire Early).
The longer your retirement, the more you’ll need in order to pull it off successfully. Be sure to measure twice and cut once, because retirement is difficult to undo once you get it started.
