If you read most any early retirement blog you’ll hear about the “4% rule” and how with a (very) rough calculation you can use it to find out when you can retire, be that entrepreneur you always wanted to be, or at least have the freedom to do the type of work that makes you happy when a paycheck does not matter. We read the 4% rule is the percentage you can draw from your lump of investments each year and not run out of money. The 4% rule evolved from calculations done by authors targeting the typical retiree starting their retirement in their 60s and living for another 30 years or so. Thus, if you want an inflation adjusted $40,000/yr in income, you divide that figure by 0.04 (or multiply by 25) and arrive at a $1,000,000 investment portfolio needed to retire. No pension, no social security, no nothing but your big lump of investments. This rule is oversimplified for folks looking to retire early and is derived from this guy’s work:
What Bengen did is use historical data to see how various combinations of withdrawal rates and portfolio makeups fared through different periods of history in the US stock and treasury market. Based off this information he determined what was the maximum sustainable withdrawal rate was in the worst year(s) to start your retirement in our past. Previously financial planners had run into trouble with clients by using a constant 7% average return rate or monte carlo simulations using randomized data, but Bengen used our history. This was really important because historical data is our best bet in predicting the future. Depending on which year you retire you may experience some of the best historical returns ever, average returns, or unfortunately you may be exposed to a sequence-of-returns risk when you start off. It’s logical for trends in our market returns mixed in with periods of inflation and deflation to repeat itself. Based off this information and some assumptions, to the extent of what the past has shown us, we can use to predict what will work in the future.
“The only lesson you can learn from history is that it repeats itself”
― Bangambiki Habyarimana,
People oversimplify Bengen’s work from 1994. Here is the cliff notes version you can use to refine your own action plan to Financial Independence and start to have some confidence for when you have enough money to retire:
- The article states values in pre-tax dollar values. It does not consider what taxes you would pay on these withdrawals.
- Expense ratios or adviser fees are not factored in.
- Data used was from 1926 through 1992. This work was completed before the Dot Com bubble and The Great Recession.
- The article looks at how a constant withdrawal rate and portfolio makeup would do starting in 1926 and carried through history, then 1927, and 1928, etc. using real market returns to see how different strategies and variables.
- Assumes a portfolio with a 50/50 stock/bond allocation.
- Uses S&P 500 index in calculations for “stocks.”
- Uses intermediate term treasury notes in calculations for “bonds,” but not a bond fund. A difference, but not a huge deal.
- Withdrawals are made at the end of each year, not the beginning.
- When withdrawing from the portfolio each year, the article assumes a constant, inflation adjusted amount based off a percentage withdrawn in the first year of retirement. No emergencies or unexpected spending.
- For simulations beginning 1944 and later, there wasn’t enough historical data to project 50 years in the future, so the author used market averages after running out of real returns.
- 3%-3.5% constant withdrawal rate lasted for 50 years or more of retirement with the 50/50 portfolio for all scenarios. This withdrawal rate with 50/50 allocation is about as safe as it gets.
- 4% constant withdrawal rate lasted for at least 33 years of retirement for all scenarios and most of the time 50+ years. Most of the time leaving some $ to heirs when retiring around age 60 with normal life expectancy (85 to 90 yrs old).
- Comparing different allocations from 0-100% stocks, when looking at the minimum portfolio life (how many yrs. until you ran out of money, which happened to be starting retirement in 1966 or 1969) with anywhere from 1-8% withdrawal rate, a 50/50 stock/bond lasted the longest for all withdrawal rates. So planning for the absolute worst case scenario, a 50/50 portfolio lasted the longest in those bad luck years to start your retirement.
- With a 4% withdrawal rate, a 75/25 stock/bond portfolio has greater longevity the overwhelming majority of the time versus the 50/50 portfolio (47 vs. 40 times the portfolio lasts over 50 years).
- In all years except for 1966 and 1969 (losing 1 yr and 2 yr respectively of portfolio longevity), the 75/25 portfolio has equal or greater longevity over the 50/50 portfolio. So for the risk of picking the absolutely worst year(s) to start your retirement, there is a payoff in time your portfolio lasts in all other years.
- With a 4% withdrawal rate, a 75/25 portfolio has a dramatically positive effect on resultant wealth after 20 years vs. other portfolio allocations.
- With a 5% withdrawal rate, the 75/25 portfolio has narrower “valleys” vs. 50/50, suggesting damage from financial events is confined to fewer years surrounding the event due to the recovery ability of stocks.
- Almost half of the 75/25 portfolio scenarios with 5% withdrawal have greater longevity than the 50/50 scenarios.
- But there is a price to pay for the 75/25 portfolio with 5% draw down. Certain major financial events hit harder, lowering the number of years the worse case scenario lasts vs. the 50/50 portfolio, but, but it still lasts at least 30 years.
- Portfolios with <50% stocks lower the amount of accumulated wealth in these scenarios significantly as well as lower the minimum portfolio longevity. Don’t go too conservative in your investment strategy.
- Portfolios with >75% stocks are to be avoided in the beginning of retirement. They do increase wealth most of the time, but they lower the minimum portfolio longevity. So if you hit on that worst case starting year in retirement, you’re going to run out of money sooner than you might like.
- Bengen recommends as close to 75% stocks as possible with most people’s comfort zone being from 50% – 75% stocks.
- So long as spending goals at the beginning of retirement remain constant, no need to change allocations along the way, in fact that can hurt a portfolio.
- You are better off reducing or holding spending levels flat during down times than messing with portfolio allocation.
- Even when your portfolio is doing really well in retirement, increasing withdrawals above the inflation adjusted initial withdrawal can be detrimental as you never know when a rough road is ahead and you might need that cushion to get you through.
So now you know where the 4% rule came from and how it gives you a value to shoot for when asking yourself how big your retirement nest egg needs to be. You also know it’s not quite as simple as I stated in my first paragraph, but I plan to post more about further investigations into the rule, retesting Bengen’s ideas as time has passed, and ways you can massage the rule to have more confidence in the guideline.