A Conversation on the 4% Rule
I had a brief conversation with Steve of the SteveArk blog, in his thought-provoking post on the 4% rule.
My initial comment was WAY longer than it should have been, but the thoughts and resources just kept pouring out of me, as I couldn’t help but think “what if somebody runs across this, a few years from now, and wants to know more?”
So I figured I might as well turn this into a post on my own blog! Perhaps I can do a better, more well-thought-out (and well-edited!) version here. So here goes:
There’s been a fair amount of hand-wringing about the so-called “4% rule” on FIRE blogs over the past several years.
The 4% rule has held up well in the past. But what about the future?
What if you’re an early retiree, so you can expect a 40-year or 50-year retirement [instead of 20 or 30]?
What if you have large, unexpected expenses like medical bills?
What’s a more prudent alternative?
So what is the much-debated 4% rule?
Basically, it is used to plan people’s retirement. According to this rule of thumb, you can (within certain constraints) withdraw about 4% of your total portfolio every year, without running out of money.
Picture it this way: over the course of your life, you’ve saved—oh, let’s say $1,000,000 in your 401(k). The 4% rule means you could withdraw $40,000 every year, and it would last at least 25 years! (1 million divided by 40,000 equals 25. Basic math).
But, given the realities of market returns over the long haul, it’s very likely that your million dollars will actually last more than 25 years. In most circumstances, it will last much longer! So, between Social Security and your 401(k) withdrawals under the 4% rule, you should have a good retirement with no worries about money. At least in theory.
Put plainly, then, following this 4% rule makes you highly unlikely to run out of money before you die.
In his post, however, Steve relates his professional experience as a chemical engineer, which showed him that simple rules (like this one) work fine—until they don’t. Even advanced artificial-intelligence software, such as he used occasionally in his job, usually chokes on unexpected occurrences and messy real-world data.
His whole piece is well worth a read! It clearly conveys the difficulty of trying to predict the future, especially in a world where large and important changes constantly take people by surprise. As an aside, that same theme keeps coming up, over and over and over again, in my life. Perhaps a higher power is trying to tell me something…
In any case, we have to start somewhere, and past data gives us a starting point in our investigation.
While I fully agree with SteveArk—using data from the past and projecting that into the future is playing with fire—there have been multiple studies, and a couple decades of additional data, that 4% is itself a pretty conservative ‘rule.’ In fact, even a 6% withdrawal rate has been shown to be pretty safe in most circumstances (check out the 1998 Trinity study for a helpful chart with various assumptions).
In essence, I’d sleep pretty well at night with a 4% withdrawal rate.
But my actual plan is to be even more prudent than that! I’m expecting to spend only my dividends, which amounts to about a 2% withdrawal rate.
And SteveArk replied that his own plans don’t really involve a specific number, but his spending comes out to a withdrawal rate of roughly 1%. I think he is wise to be cautious, and his replies to various other commenters betray that he clearly knows quite a bit more than he lets on in his initial post.
So, for those who may be interested in learning more, here’s a more detailed overview of the matter, complete with links to helpful resources and academic studies. Feel free to bookmark this page and come back later!
I’m a big fan of the old aphorism, “Give a man a fish, and he’ll eat for a day. Teach him how to fish, and he’ll eat for a lifetime.”
So here’s your fishing lesson:
1. When it comes to your withdrawal rate, flexibility is key, as numerous experts have said. Wade Pfau, Bill Bengen, and Michael Kitces are three well-known researchers on the matter of retirement planning, and they all emphasize the importance of flexibility, rather than relying on a fixed rule like “always withdraw exactly 4% of your total portfolio each year.”
But for planning purposes, it helps to have a fixed percentage. 4% is easy, in part because it translates to “multiply your expenses by 25, and that’s how much you need to save.”
What’s that, you say? You spend $25,000 per year? Then you need to save $625,000 for your retirement ($25,000 times 25).
Oh, you, over there? You spend $85,000 per year? Then you’ll need to save $2,125,000 ($85,000 times 25).
And you, in the back row? You don’t know how much you spend, but you earn $60,000 a year? Well, assume you pay about a quarter of your paycheck in taxes. One-quarter of $60,000 is $15,000.
So, $60,000 [your salary] minus $15,000 [your tax bill] leaves you with $45,000. If you live pretty much paycheck-to-paycheck, then your annual expenses are about $45,000, which means you’ll need to save $1,125,000 to meet the 4% rule.
Now, it’s actually more complicated than that.
What about Social Security payments? That will reduce your need to save (hooray!).
How about if you get an inheritance?
Or maybe you plan to move to a poorer country after retirement, which will slash your expenses while maintaining your standard of living.
Questions like these are where it gets complicated, and where a fiduciary advisor can really help you with your planning. I have no way to know your financial position, dear reader, nor do I particularly want to wade around in the sticky details of someone else’s private information.
I’d rather show you some principles and resources, and then you can work it out to your heart’s content.
2. “But if I have my money in investments, which go up in value over time, won’t I have to save less?”
A good question. And yes, that is true.
“So…if my investments earn 6% per year, does that mean I can withdraw 4% + 6% = 10% per year?”
No!!! Are you trying to go broke?!
That’s highly risky; the rules calculated by Bengen and by others already take this into account. And, while a 6% withdrawal rate works most of the time, the success rate of the strategy declines rapidly once you pass that 6% mark.
The reason is mathematical. Markets tend to drop faster than they recover, and the recovery is seldom fast enough to make up for the losses.
A simple example: You have $100 in the market. It drops by 30%, which leaves you with $70 in the market.
For those of you following at home, get your calculators out. 100% – 30% = 70%. Expressed as a decimal, 70% is 0.7. So take your $100 and multiply by 0.7, and you’ll end up with $70.
Then, the market has a 30% gain. Yay! You’re back to $100, right?
Wrong. Those $30 are gone. Your new starting point is $70.
Get those calculators warmed up again. 100% + 30% = 130%, or 1.3. Now, take your new starting point of $70, and multiply by 1.3, and you’ll get $91.
So, a 30% decline, followed immediately by a 30% gain, does not get you back to the break-even point. The end result is a loss of 9%.
Now, if you’ve pulled your 10% withdrawal, thinking that market gains will make up for your large withdrawal, that might be true during a good stretch. But during a bad stretch, you’ll be compounding your losses instead of your gains. History shows that the market is unlikely to move fast enough for you to catch up.
In fact, a 30% decline is rarely followed by an immediate 30% rise.
You’re more likely to see a sequence like this: a 30% drop, then an 18% rise, and another 10% rise, followed by another 8% gain the following year, and a nice 14% gain after that, followed by a 2% loss, and then an 8% loss, followed by a 5% gain, and so on.
When you’re withdrawing a high percentage every year, and you hit a sequence like that—you might never recover.
Yep, better to be prudent. Make conservative estimates. Don’t assume everything will go fine, and don’t assume the averages will work out over time. And definitely don’t try to add percentages together, like assuming a 30% gain cancels out a 30% loss—because, as we’ve just seen, it doesn’t!
3. Now that I’ve scared you witless, I can show that, historically, things really aren’t that bad.
In fact, Bill Bengen—author of the original 4% rule study in 1994—has updated his rule more recently, to 4.5%.
That’s right, the guy who created the famous rule actually raised his recommended withdrawal rate!
In one of my favorite pieces on the topic, Michael Kitces demonstrates that a retiree has a 10% chance of ending up with a lower balance than she had on her retirement date…but also a 10% chance of ending up with *six times* her original balance at retirement!
The same study shows that, at a 4% withdrawal rate, there’s an equal chance of a portfolio going down to zero…or increasing by 800%!
That’s right—by following the 4% rule, you have a very small chance of ending up broke…or an equally small chance of ending up with 8 times as much money as you had when you retired!
Now that is an asymmetric risk/reward profile: an equivalent risk of a 100% loss or an 800% gain! If we were discussing a game of chance, that game would bankrupt the casino!
But, fortunately, investing is not a zero-sum game. As long as publicly-traded companies remain productive, it’s a game where a rising tide lifts everyone’s boat. If it’s played well and governed fairly, it’s possible for everyone to end up better-off.
4. Everybody’s different.
Everybody has different goals. Some want to leave money to their heirs; others want to leave a windfall to charity; still others want to spend all their money while they’re still alive to enjoy it.
Everybody is in a different situation. Some people have saved more money than they could hope to spend, while others will rely on Social Security just to stave off hunger.
Some are in a better position but are naturally conservative investors; others are in a worse position but are naturally more aggressive investors.
So that makes it difficult to make a one-size-fits-all rule. Because one size will never fit everyone.
But the 4% rule is close.
5. “So what withdrawal rate should I use?”
Good question. As I explained above, it depends on factors like your personality and your situation, as well as the behavior of the market in the future—things that I couldn’t possibly know!
The 4% rule is a great place to start, and you can tweak it from there according to your needs and desires. But in order to tweak it, you’ll need to educate yourself. I’ll include some links to helpful resources shortly.
6. Flexibility is key. Numerous experts agree on this point.
If a recession is looming, that might not be the best time to buy an RV and go on a cross-country tour (unless you’re supremely confident in your financial position. If you can weather an extended downturn and still have more money then you need, then enjoy your trip!).
But if things have been going very well, and your investments are throwing off more cash than you’re spending, that may be a good opportunity to withdraw some extra money and put it in the bank for a rainy day.
I won’t issue a blanket recommendation of “always follow the 4% rule,” even though I could point you to several sources that would support such advice.
As SteveArk astutely noted, the future is truly impossible to predict.
The 4% rule will probably work fine. And if it doesn’t, maintaining your financial flexibility will help a lot.
The financial system isn’t likely to fall apart. And if you’ve prepared yourself well, a whole lot of people will be in deep trouble before you notice a strain on your own wallet.
The best advice I can give? Prepare for a 4% withdrawal rate (or lower, such as my own planned 2% withdrawal rate). Why have that much cushion in your plan? Because, even if the rest of the country goes to pot, you will still be in decent shape while everybody else is screaming for relief.
7. Helpful resources:
A scanned copy of Bengen’s original 1994 paper: https://www.optimizedportfolio.com/wp-content/uploads/2021/04/Bengen.pdf
The famous 1998 Trinity study, complete with useful tables: https://www.aaii.com/files/pdf/6794_retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable.pdf
Kitces’ excellent research summary from 2019; one of my favorites: https://www.kitces.com/blog/url-upside-potential-sequence-of-return-risk-in-retirement-median-final-wealth/
A good analysis of various studies from across the years: https://www.optimizedportfolio.com/4-percent-rule/
Dr. Wade Pfau, who bills himself as “The Retirement Researcher,” has written books on the topic of retirement planning. He is also a professor at The American College of Financial Services and a director of retirement research for McLean Asset Management. So, he is indeed an accredited expert, though I’ve found his writing a bit dense and academic at times, which means it may be tough for some readers to slog through. But that’s not always the case; here’s a good example of his best work: https://retirementresearcher.com/taking-portfolio-spending-real-world-retirees/
Another interesting one from Dr. Pfau is https://retirementresearcher.com/asset-allocation-look-retirement/, in which he discusses the possibility of changing your asset allocation during retirement, based on the Shiller P/E ratio of the stock market at the time. If you’re interested enough in investing, you may want to consider this approach (but it’s not for the ‘I’ve-got-better-things-to-do-than-watch-money’ crowd).
A simple retirement calculator: https://firecalc.com/
A better alternative, which I use myself sometimes: https://cfiresim.com/
I strongly recommend playing with the settings on one of these simulators, because doing so will raise a number of questions, questions that people have probably answered already. But struggling with the problem makes the solution more interesting.
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Check out my book-review series, available now:
1. Debt: The First 5000 Years by David Graeber
2. Rich Dad Poor Dad by Robert Kiyosaki
3. The Clash of the Cultures by John C. Bogle
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