The 4% Rule

Since we’re talking early retirement and specifically my goal of retiring at 45, I thought it’d be a good time to discuss the 4% rule and what it’s all about.

After all, retiring early at 45 means you need cash flow to cover your expenses that will last a substantial amount of time without forcing you back to work. Your portfolio generally becomes your income and the idea behind early retirement is to be able to keep your current lifestyle without needing additional income.

Sure one can work in retirement(so not really be retirement) or earn extra money via some side hustle but that’s no fun!

The 4% rule and the Trinity study that it stems from is meant to define safe withdrawal rates from your portfolio that will help you do that and sustain you for an extended period of time without running out of money. That’s the dream right?

What Is the 4% Rule?

In simple rule, the 4% rule says that you can safely withdraw 4% of your original portfolio, adjust that for inflation every year, and not run out of money for 30 years.

The goal is to define a safe withdrawal rate that will help keep your portfolio intact and your lifestyle supported with money!

Imagine a portfolio of $1,000,000 and a withdrawal rate of 4%. That means that a retiree following the 4% rule should be able to take out $40,000 in year one then adjust for inflation in the following years(so assuming 2% inflation would make it $40,800 in year two, $41,616 in year three and so on) and not run out of money by the 30th year of following this strategy.

So why does this work? Well, the basic idea is that long term market returns depending on the asset allocation will eclipse the 4% withdrawal rate. In most cases, it will leave the retiree with more than $0 after thirty years which is all that’s needed to sustain the lifestyle for that time period. In fact, in many cases, the strategy will actually leave the retiree with more money than they started with if market returns exceed withdrawal rates for an extended period of time. That may seem counterintuitive given you’re taking money out but it’s happened quite often in the historic data set.

While the market may be volatile in the short term, in the long term, it has produced relatively stable positive returns that make this withdrawal strategy work.

One thing to remember is that at the end of the day, early retirement is a success if a person dies with their costs being covered for the entirety of their life. That’s what the 4% rule is meant to ensure.

It doesn’t matter if you’re left with $1,300,000 or $59,000 at that point. As long as your expenses were covered for the entirety of your post work life then the withdrawal rate was a success. It’s important to define that safe withdrawal rate that will help make that happen because the worst thing that could happen in early retirement is missing and running out of money too early.

If your $1,000,000 above suddenly runs out 12 years into retirement because you picked a withdrawal rate that was too high then you have a problem and might have a struggle in getting back to work.

Where Does the 4% Rule Come From?

The 4% rule is based on a 1998 study informally called the trinity study(named after three trinity professors) that back tested certain portfolio allocations against various withdrawal rates and time periods. The 4% rule refers to one of the scenarios tested by the authors(they tested withdrawal rates from 3% to 12%) that was deemed the best combination of success rates and payouts on a long(30 year) basis.

The various asset allocations tested in the study ranged from 100% stocks to 100% bonds and three allocations in between(75/25, 50/50, 25/75 stocks/bonds) which all yielded different results. The time period for the back testing was 1926 to 1995 which yielded a variety of unique 15-30 year periods to test against.

In this study they defined portfolio success rate as the investor’s portfolio outliving in the investor’s planned payout period. In the above example, if your $1,000,000 was still covering your cost in the 30th year then it was a success. If you ran out of money before that period then it was a failure.

While they back tested using years from 1926 to 1995, they also did a test excluding the Great Depression and WWII which yielded better results and ran from 1946 to 1995. However, they also realized that looking at things in a more positive light didn’t always yield the most useful results as the post-war period might be too optimistic and a longer period provides a longer distribution of returns and covers more market conditions.

Given that information, they only used the longer period in testing the inflation adjusted number which I believe are more relevant since inflation impacts your purchasing power and has to be accounted for in the calculation. In essence, an investor who starts using $40,000 in year 1 can’t also spend be assumed to spend $40,000 in year 30 because their purchasing power would be greatly impacted by then.

So what did the results yield and how was the 4% rule established? Well you can see all that below in the table that was included within the trinity study and tests the various withdrawal rates against holding periods with 5 different allocations.

So what does this tell us? Well, first, the 3% withdrawal rate is pretty darn safe across all payout periods as long as there’s some allocation to stocks.

In fact, if you’re looking for safety, anywhere between 3-4% is the spot to be given the 95%+ chance of success across 30 years when your portfolio includes at least 50% stocks.

One key thing here is that the success rates start to drop with higher allocation to bonds as bond returns sometimes fail to keep up with 4%+ withdrawal rates across the long term. You can see that in the 100% bond allocation which fails 80% of the time at 4% across a 30 year period.

However, bonds are by no means useless as a 25% bond allocation actually performs better than an allocation with no bonds across a 30 year period with a 98% success rate against a 95% success rate with a 100% stock allocation. The reason for that is that bonds can even out returns and prevent massive drawdowns during bear markets when stocks suffer.

One important take-away here is that as withdrawal rates start to get past 5%, the success rates start to drop off precipitously especially with a longer time frame. This drop is slower with higher stock allocations(as those have higher returns) but even a 6% withdrawal rate with at least 75% allocation to stocks only has a 68% success rate across 30 years. That’s still not a disaster but I’m not sure a retiree will be comfortable with a 32% chance of running out of money. I certainly wouldn’t be.

That leads the researchers to believe that anything past 4% adds additional risk to long term retirement projections and retirees may want to stick to a number lower than that; thus the 4% rule.

In essence, based on this data, if you want to have a safe retirement then make sure you have at least a 50% stock allocation and a withdrawal rate of 4% or below. That will almost guarantee that you’ll be able to succeed in your retirement goals and have enough money to remain stable when you’re no longer working.

In fact, at these levels, you can often actually build wealth while spending money as the stock market can often return more than your inflation adjusted withdrawal rate.

That’s shown in the below table that was also included in the study.

This table shows the terminal value(end value of the shown payout period) based on a start portfolio of $1,000 and the suggest withdrawal rates along with the three separate asset allocations.

You can see that a a 4% withdrawal rate with a 75% stock allocation, the average end point is $9,031 meaning that the investor’s portfolio grew quite a bit after 30 years despite the regular withdrawals.

This may lead you to believe that 4% is a bit too conservative but you can see that going to 5% leads to minimums that start to show a $0 end point meaning the 30 year period ended with the investor having no money to use for life expenses.

As always investing comes with risk so while the 4% rule isn’t the only answer, it seems to be the realistic number to aim at, for those that don’t want to risk running out of money during their period. However, in many scenarios, the 4% rule will mean that your $1,000,000 starting point will actually grow to quite a bit more despite your regular withdrawals.

The simple way to think about why that happens is that historical stock returns have been in the 8-10% range and if that continues during your withdrawal period then your 4% + inflation withdrawals will actually trail the stock market in the long run. That’s certainly not a bad thing and having more money after 30 years to either bequeath on your heirs or to allow you to spend more wouldn’t be too bad of a problem to have.

So is 4% the right answer based on this study? It’s certainly a number that makes sense but there are some concerns with using it as a gold standard.

The Flaws of the 4% Rule

While the 4% rule provides a simple approach to retirement planning, one must remember the flaws that come with it.

First and foremost is that the study is based on the assumption that you’ll access the funds for 30 years which may be long enough for some but not all. For example, those retiring early may need their funds to last 50 years which isn’t accounted for in this study.

Often, a longer period actually helps the calculation as a longer period of time helps smooth out the returns but that’s not always the case especially if you run into a long term bear market in that time period.

Secondly, the data in the study is based on stock and bond returns until 1995 which misses the most recent years that may be more relevant to future returns. Luckily, there are plenty of online calculators like FireCalc which can help run simulations and generate success rates based on more current data. I always suggest running those before committing to a number.

As an example of how that old data may be less relevant, bonds in 1998 yielded 5.3% against an inflation rate of 1.55%. That’s against average yields of 0.89% in 2020 against inflation of 1.23%. That number is even worse with a 1.44% average yield in 2021 against inflation numbers hitting 7%. The reality here is that bonds were a lot more fruitful in the time period shown here in smoothing out portfolio returns and may not be as useful going forward.

On the stock side, the highest Schiller PE during the test period was just north of 30 during the Great Depression and we all know what happened then. This number hit 44.19 in 1999 which was followed by 3 years of very negative returns and now sits at 39.57. That’s not to say that the number is a great predictor of future returns but it may mean that future returns may be less favorable than they have been in the study given that investors are paying more for each dollar of earnings today than they have in most of history. However, part of that is due to the low bond yields talked about above as well so it’s possible that’s also the new norm until yields trend up(if they ever do).

Still, projecting return is one the greatest issues that comes with any withdrawal strategy. If your expectations are 7% returns and they turn out to be 4% then your withdrawal strategy will certainly have a much bigger chance of failing.

Another big threat to a safe withdrawal period even if long term returns are favorable is something called sequence of returns risk. This defines risk that exists based on the order in which your returns occur.

I’ll cover this in more detail in another post but in simple terms, if you retire and the first few years of your retirement produce very negative returns(like in 1999), your success rate is greatly diminished even if followed by positive returns. However, if you retire and the first few years of your retirement produce very positive returns, your success rate is greatly increased even if negative returns follow.

Another important thing to consider are taxes which unless you’re withdrawing from a Roth IRA will impact how much money you actually get to use for expenses. For example if you want to cover $80,000 in costs, you may actually need to take out closer to $100,000 to cover federal and state taxes. That number may be lower if you’re married but in most scenarios, you’ll need to take our more money than just your expenses because taxes will still impact those dollars in some way.

There’s plenty of other things to think about as a person who’s almost ready to retire such as planning your expenses and planning for unexpected costs and other things but given that I’m years away from actually retiring, it’ll be something I think about closer to retirement rather than today.

The Bottom Line

The 4% rule is a good starting point for investors thinking about retirement. It’s certainly proven to be effective across a long period of time but more current data needs to be taken into account.

Luckily the magic of the internet allows users to find websites like FireCalc to calculate their own odds at success based on various factors and that’s something I plan to do and share in the next few posts and probably revisit each year as I get closer to retirement. Considering sequence of return risk and how it may impact your retirement strategy if you retire when the stock market is priced at a high level and proceeds to fall after retirement is important too.

There are also two parts of the equation and the second part is your actual spending which will define how big a portfolio one needs to cover spending. If your withdrawal is $100,000 each year(which would yield less after taxes) and you don’t expect that to change in retirement then your portfolio needs to be at $2.5M to cover that with a 4% withdrawal rate. If you want to be a bit safer and choose a lower withdrawal rate then a higher portfolio is required.

It’s important to track spending for a few years before retirement and figure out where you want that number to be. Also, one has to remember that the study assumes consistent spending every year which likely won’t happen for most retirees. Some years might be higher while others may be lower.

You also have the option to spend less when the market is struggling and spend more when the market is doing well which can impact your success rates positively.

My plan right now is to start around doing more research around a 4% withdrawal rate but my cautious nature likely means my withdrawal rate will be somewhere in the middle of that 3-4% range that was tested in the Trinity study. For me personally, that seems to offer the best success rate and given that I’m retiring early, I really want to make sure my money can last as long as possible.

On the opposite side, being too conservative may also mean you’re left with a ton of money after your retirement period is done and maybe that’s not something you want so it’s a very fine line to walk to make sure your retirement is a good combination of success and enjoying life with the money you’ve saved. For most, I think 4% is the right starting point but more risk tolerant investors can look at the data and potentially aim for something higher especially if they believe returns in the future will be as high as they have been historically(or even higher).

One thing to remember is that the Trinity study only tested time periods of 30 years so longer periods might have completely different success rates and a lower withdrawal rate will make success much more likely.

As I mentioned before, retiring right before a bear market and a big stock market drop can also impact your success rates negatively. That’s something I plan to cover in future posts so stay tuned because there’s a lot more to the 4% rule than just the Trinity study.

It’s certainly not an infallible rule and at the end of the day, the future success rates will entirely depend on future returns which are unknown. However, given the history tested here, it’s a good starting point for any future analysis that an investor might do when planning for retirement.