What is the 4% Rule in Retirement?

 in Blog / Invest
Boats traveling in the water.

When you start planning for your retirement, there is one question that you must ask yourself.

How much is enough?

 You may hear about fancy financial rules that you don’t know much about. One that is constantly discussed is the 4% rule in retirement.

The 4% rule is one of the rules of thumb thrown around in the finance world. It is also known as the safe withdrawal rate or SWR.

What is the Safe Withdrawal Rate?

The safe withdrawal rate simply refers to the amount of money you can safely withdraw each year, without running out of money.

It sounds simple but has become a topic of controversy for some time. Inflation is the factor that makes this number hard to nail down. Will a gallon of milk cost $5 in the future or $15? Nobody can truly predict our future expenses.

What Is The 4% Rule In Retirement?

The 4% rule in retirement pertains to the withdrawal rate. This is the amount you can withdraw every year based on the starting value in your portfolio. Let’s say you have $1,000,000 upon retiring. The 4% rule suggests that you can withdraw around 4% of that amount, meaning $40,000 each year. Assuming that your portfolio is invested in index funds, your money will probably last for around 30 years, even with inflation.

So where does the 4% rule come from?

It comes down to good old fashioned math. If you take your annual spending and multiply it by 25x, you will have your retirement number. For example, if you spend $100,000 per year, you would need a 2.5 million dollar nest egg to maintain that your lifestyle.

 If you invest in an index fund that returns 7% per year, inflation will eat up 3%. What you have left is 4% that can be safely drawn down.

History Of The 4% Rule In Retirement

The Trinity Study  put the 4% rule on the map. It was published in 1998 by three professors from Trinity University in Texas.

By now I bet you can guess where the name came from.

The study analyzed various retirement portfolios held up over a 30-year period

After the study, this rule often became associated with a withdrawal rate that was safe for retirement.

The conclusions that the study actually withdrew included:

  • At least 50% should be allocated to stocks since that would be most beneficial for the retirees.
  • A reduced withdrawal rate should be accepted from the initial portfolio if retirees demand CPI-adjusted rates for withdrawal.
  • Withdrawal rates of 3-4% represent conservative behavior for portfolios that are dominated by stocks.

Keep in mind that the Trinity study also has a number of assumptions. It assumed a retiree will NOT:

  • Collect a single dollar from social security or any other pension plan
  • Earn any more money through part-time work or self-employment projects
  • Adjust spending to account for a huge recession or depression
  • Spend less as they age (which most people do)
  • Substitute goods to compensate for inflation or price fluctuation. (Spend less on groceries, downsize their cars, or forgo a vacation.)
  • Collect any inheritance from the passing of parents or other family members

The Trinity Study Updated

The same professors later updated their research in 2011. The conclusions of the study suggested that clients who want to make annual withdrawals adjusted for inflation should plan lower initial withdrawals within 4-5%. The study found that a portfolio should have at least 50% of common stocks and 50% bonds.  If this portfolio is maintained the retiree should be able to maintain their nest egg at a 95% success rate.

However, some researchers have critiqued the study since it doesn’t take into account mutual fund fees or the fact that this rule doesn’t hold up as well in the US’s economy. You should also take into account the fact that at least one spouse from the married couple retiring at the age of 60 years will live for more than 30 years.

Yet based on the assumption listed above, it is a good rule of thumb because it does not take into consideration any extra income outside of your investments. When you use it as a general guideline and put a plan into place, you should not have any issue to maintain your nest egg.

Does the 4% Rule hold up If I Want to Retire Early or Pursue My Passions?

4% rule motto

The short answer is yes it does. But, one thing to consider is that most early retirees decide to work on projects and passions that end up making them money. Those who do this have now turned their retirement income into 2 or 3 streams.

The three streams then become:

Passive – This is your investment in index funds, dividend stocks, etc. Your 4% rule income.

Government – This is your social security or pension. Remember, the Trinity Study did not include this in the 4% rule. You will obviously expect this later in life.

Enjoyably Active – This is money you make surrounding your hobbies and passions. For example, mine is writing about personal finance. This is an income stream for me.

The enjoyably active income stream is one that you can organically grow. It can be anything from starting a part-time business to flipping homes.

This means that you should try to build your nest egg up to hit the 4% rule, but it is not the only way! Blending active and passive income can be a wonderful way to live your retirement and allow you to stay active while pursuing your passion.

In fact, it may be the way to the most fulfilling retirement. Studies have shown that earning additional part-time income for 10 years can reduce the nest egg you need by over 30%

Conclusion

Keep in mind that the 4% rules is based on historical data. Markets can ebb and flow in the future.

 If market returns are reduced in the future, the 4% rule may not hold up. Consider adding additional income streams to your retirement to ensure you can live the comfortable retirement you worked so hard for.

andrew
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