The 4% Rule
The 4% rule is one of the most talked about rules of thumb in the world of financial independence. It’s research based, well tested and most importantly, simple. So in this post we are going to deep dive into the 4% rule so you can start applying it to your own personal journey towards financial independence.
The Origin
Where did the 4% rule first originate from? Let’s wind the clock back to 1998. Three professors from Trinity University were curious to know the ideal withdrawal rate on an investment portfolio. So, in order to find out, they ran a whole bunch of scenarios.
Over a thirty year period, they applied different withdrawal percentages ranging from 3 to 12% to various portfolios, each with a different mix of stocks and bonds. And the finding turned out that on a 50/50 stock to bond portfolio adjusted for inflation, the 4% withdrawal rate allowed the portfolio to remain intact 96% of the time.
This means that if you had a $1,000,000 portfolio invested in a 50/50 stock to bond ratio. And if you withdrew 4% from it every year for 30 years straight, there was a 96% chance that your portfolio would remain intact at the end of 30 years.
The Application
Now, I’m excluding a lot of other considerations such as inflation adjustment during withdrawals, tax implications and timing of when the failure can happen. But the findings from this study, also now more famously known as the Trinity Study, serves as an easy way to determine how much of your nest egg you can spend each year without running out of money.
Simply, if you can live off 4% of your investment portfolio, you are effectively financially independent. And if we use the inverse of 4 percent, we would need to accumulate twenty-five times our annual expenses to be financially independent.
Let’s look at some examples. If you currently spend $40,000 per year and want to maintain that spending, you would need a portfolio of $1 million. $1 million x 4% = $40,000. If you spend $80,000, you would need a portfolio of $2 million. $2 million x 4% = $80,000. And you get the same result if you were to multiply your expenses by 25. $40,000 times 25 equals $1 million. $80,000 times 25 equals $2 million.
Of course, we want to note that there is no guarantee that our money will last forever. As this depends on other factors that are out of our control such as actual investment returns and inflation. So let me share with you several key takeaways as regards to the 4% rule that you could keep in mind as you apply it to your future planning.
Takeaway 1 - Guideline, Not A Hard Rule
The number one takeaway from the 4% rule is that it should be used as a guideline, not a hard rule. Stock markets are volatile. Interest rates change. And the economy is unpredictable. So using the 4% to figure out how much you need to be financially independent is similar to using google maps to determine how long it will take you to get to work.
You plug in your destination into your google maps and it shows you an estimate of how long it will take you to get there. The 4% rule is similar. It gives you a rough idea of how long your drive will take or your money will last. Of course, similar to market factors, there are tons of factors to this driving estimate. The time of day, traffic, or a major unexpected accident on the way.
If you decide to drive to work during peak traffic time, it can take you 30 minutes longer to get there. But if you decide to drive to work at 1 in the morning, you could get there 30 minutes faster. The average driving time gives you a rough estimate of how long the drive could take, but so many factors can change the actual driving time.
In the same way, the 4% rule can give a rough estimate of your retirement amount. Or if you are halfway there. But the actual execution will be determined by the timing of your retirement and the market situation then. And It could also be affected by your own personal behavior.
What happens if your expenses drop after you retire because you no longer need to pay for work commuting? Then the probability of your money lasting longer increases. Of course, this works the other way as well. If your expenses go up after retirement due to health or other reasons, then the probability of your money lasting decreases. Use the 4% as a guideline and then you can adjust to new conditions on the ground as you encounter them.
Takeaway 2 - High Income Is Not A Prerequisite
The second take away from the 4% rule is that high income is not a prerequisite for retirement. Or even early retirement. It’s easy to assume that in order to save enough money for a comfortable retirement, we need high income. Multiple six figures. However, When we are running the 4% calculation, what we notice here is that we aren’t talking about income at all.
Everything is essentially driven by how much we need to live on. The expenses. Therefore, if you have a low expense lifestyle and a decent income to grow your portfolio to that 4% amount, you are technically financially independent.
Let’s look at an example. Let’s say we have two individuals. A doctor with a high income of $400,000 and a carpenter with modest income of $40,000. And their lifestyle is tied to the amount they make. The doctor with the $400,000 has a lifestyle that spends 90% of his income. His big home, luxury cars and fancy vacations cost him $360,000 a year. So he is only able to save 10% of his income for retirement. About $40,000 a year.
The carpenter also has a lifestyle that spends 90% of his income. His housing, food for his family and modest weekend trips cost him $36,000 a year. And he too therefore saves 10% of his income. About $4,000 a year.
Now, the difference between $40,000 and $4,000 is significant. The doctor is saving 10x the amount that the carpenter is saving. However, the time they have until they have enough for retirement is actually the same. Ironic isn’t it? Using the 4% rule, the doctor needs 25x the $360,000 in order to maintain his lifestyle. About $9,000,000. The carpenter needs 25x the $36,000 in order to maintain his lifestyle. About $900,000.
For both, if they are saving and investing 10% of their income annually, at an 8% annual return, it will take them approximately 38 years before they are financially independent. Remember, the doctor makes 10x what the carpenter makes. However, they are retiring at the same time because of his lifestyle expenses. High income is definitely not a prerequisite for financial independence. For many, it could actually be a hindrance because people with high income oftentimes have a high lifestyle they need to continually fund.
Takeaway 3 - Avoid High Fees
The third key takeaway from the 4% rule is the critical importance of avoiding funds with high fees. And when I’m talking about high fees, I feel like any funds that have expense ratios higher than 0.25% is too high. For actively managed fees, it is not uncommon for investment advisors to charge an annual fee of 1% expense ratio. Some even go up to 2%.
What this effectively does is undercut the 4% rule. When you have to pay an advisor 1% every year from your fund, instead of taking 4% from your investment, you can only take out 3%. And when you have a sizable nest egg, this really adds up.
Imagine you worked hard to amass a $1,000,000 portfolio. This effectively means, if you are able to live off $40,000 annually, you are now financially independent. However, imagine that your $1,000,000 portfolio is invested with an investment manager who charges you 1% expense. You are paying that investment manager $10,000 annually to oversee your money.
Now compare that with the cost of a low cost index fund like Vanguard Total Market Index Fund, VTSAX. My personal favorite index fund. VTSAX has an expense ratio of 0.04%. This means that on a $1,000,000 investment portfolio, you are only needing to pay $400 annually for Vanguard to secure and manage this fund for you.
I don’t know about you, but I take $400 over $10,000 any day. But what is worst of all is that very few of these actively managed funds beat the index over time. In 2013, Vanguard studied over 1,500 actively managed equity funds over a 15 year period and found that 82% of the funds failed to outperform the simple index.
But actively managed mutual funds will never advertise that they have a horrible track record. They instead just bury the underperforming ones and launch new funds to entice new investors. Therefore, when we start paying 1-2% annual fee to active mutual fund managers, all the forecasts from this study is essentially invalid
And to nail the coffin on this takeaway, when the trinity study was done, it did not take into account the potential for investment management fees to reduce return over the life of the portfolio. Wade Pfau, Professor of Retirement Income at the American College for Financial Services made this observation with the Trinity study and high fees.
On a 50/50 stock to bond portfolio over 30 years, 4% withdrawal rate has 96% success rate. However, when the portfolio fees are at 1%, the success rate drops to 84%. Then at 2% expense, the success rate drops to 65%. Avoid high fees at all costs. It's only making money for the overpaid fund manager and none for you. You would do so much better investing in low cost index funds and managing your own investments.
Takeaway 4 - Risk, aka Stocks Are Crucial
The fourth key takeaway from the 4% rule is the importance of taking risks as regards to your investments. And this means having enough stocks in your portfolio. When we are talking about the 4% rule, we are mainly focused on how much we can withdraw. However, what we don’t want to forget is that the success rate of this model working is highly dependent upon the asset allocation. The allocation between stocks and bonds.
The Trinity study ran their scenario on various asset allocation and the success rate differs quite a bit based on what percentage of stocks and bonds you have in your portfolio. For example, for a portfolio with 75% stocks and 25% bonds, over a 30 year period where withdrawals are adjusted for inflation, the success rate of 4% annual withdrawal rate is 100%.
However, when we change the stocks to bond composition to 50 / 50, the success rate drops to 96%. And it keeps going down from there based on what percentage of stocks we hold in our portfolio. At 25% stocks and 75% bonds, the success rate drops to 80%. And finally at 100%, the success rate drops to 35%.
This means that if you are super risk averse and decide to hold only bonds in your portfolio, the probability that your money will last you for the next 30 years is only 35%. You have a 65% failure rate. The bottom line is that holding stocks is critical to a portfolio’s survival rate. Yes, stocks come with risk. They are highly volatile and move with the whim of the market. And for many, that could be scary. You don’t want to lose your next egg. However, with risk comes reward and if we want to reap the reward, we need to take some risks. It may not be 100% in stocks, but maybe at least 50% or even 75%.
Takeaway 5 - To Retire Early, Spend Less
The number five key takeaway from the 4% rule is my favorite. In order to retire sooner, or to reach financial independence earlier, the key is to spend less. When I was first introduced to the 4% rule, it took me a while to wrap my head around its application. The 25x my lifestyle seems so daunting.
However, what I realized was that the key to reaching my financial independence number wasn’t dependent upon my income, but rather my expenses. Or to clarify, how expensive my lifestyle is. When we first started investing our money, we struggled to save even 10% of our income. We had babies to take care of and it felt like we had to add constant new expenses to keep up with our neighbors lifestyle. How was I going to make enough money to accumulate 25x my expenses?
However, I had a lightbulb moment when I realized instead of trying to reach a 4% number tied to my current lifestyle, what if I decreased my lifestyle. With less financial need, we could reach our goal sooner. When every dollar we cut from our budget meant we could reach our 4% number sooner, we got really pumped and excited.
Mr. Money Mustache, one of the most well known financial independence bloggers, shared an article titled “The Shockingly Simple Math Behind Early Retirement” in 2012. Essentially what he said in the article was that savings rate and financial independence are directly correlated to each other. When our savings rate goes up there are two things that actually happen. One, we are saving more and growing our investments.
However, the second, more overlooked part is where the magic actually happens. We spend less. And when we spend less, the amount of money we need to reach financial independence goes down.
For example, let’s say our annual income is $100,000 and our lifestyle costs us $80,000. This means we have a 20% savings rate. Because you need to build a nest egg that can fund $80,000, at a 8% estimated annualized return, it will take you approximately 28.5 years before you can retire.
However, let’s say you go buck wild and cut your lifestyle to $50,000 a year. Forget the after school for kids and you travel hack your way into never paying for vacations again. You essentially increase your savings rate to 50%. You are saving more and you need less to fund your new lifestyle now. How long will it take for you to reach your financial independence number? About 14 years. You cut your retirement time by half.
When we look at it this way, you start to think that the after school program was overrated anyways, right? The 4% is a great rule of thumb to measure your progress towards financial independence. Use it to see how far you are away from your number.
