A popular rule of thumb for financial planners and bloggers is the 4% rule. This rule states that a diversified portfolio of stocks and bonds will allow investors to withdraw 4% of their portfolio every year without any risk of running out of money. For people trying to find out what their target retirement number is, this can be a very simple, valuable tool. Simply take the amount of income you would need annually to retire (before taxes), and divide it by 4% (or multiply by 25, they equal the same thing).
Spending in Year 1 of Retirement / 4% = My Portfolio Retirement Number
This shockingly simple equation has tremendous implications for your financial journey. However, before we get into why this is important, let’s go back to how the 4% was discovered.
In the 1990s, a financial planner named William Bengen published an article called “Determining Withdrawal Rates Using Historical Data”. Several years later, a group of professors at Trinity University validated and expanded on the study using more rigorous statistical analysis. In it, the authors back tested different withdrawal rates across a 15 and 30 year time horizon using stock market data from 1925 to 1995. For example, what the authors wanted to know was, if an investor withdrew 10% of their portfolio every year for 30 years, what percentage of time periods would they have run out of money. By testing different withdrawal rates across all historical investing periods, the authors concluded that:
“If history is any guide for the future, then withdrawal rates of 3% and 4% are extremely unlikely to exhaust any portfolio of stocks and bonds”.
And thus the 4% rule was born, and it has remained the bedrock of retirement planning ever since. The chart below shows what the safe withdrawal rate would have been for every individual time-period back to 1925.
Today, there are many factors and articles that stress that 4% might be too high, while some people, like Rich Dad Poor Dad’s Robert Kiyosaki argue a rate as high as 7% is perfectly fine. In a later article, I will go into how and why you might want to adjust the 4% rule for your own planning. For now, however, the 4% rule remains one of the best ways to measure your retirement number.
What does the 4% rule can tell you about your own financial journey
- The 4% rule can provide you with a pretty good idea of where you need to be to retire. A person who expects to need $80,000 per year in annual income would need $2M to retire. With that target number in mind, we can begin to make saving and investing choices to help get us there.
- You can assess how long it will take you to get there. $2M might be a long way off for someone who is only able to save $5,000 per year towards retirement (approximately 45 years given an 8% annual stock market return). However, for the person who is able to save $2,000 per month, $2M could be achieved in a more reasonable 26 years.
- It emphasized the important relationship between spending and savings. The equation above is so simple because there is a direct relationship between net worth and spending. To cover $1 dollar of spending, you must save $25 more dollars. However, with a focus on budgeting and spend reduction, you can turn that sentence around. Every dollar I take out of my spending is $25 I don’t have to save. What this means for you is less stress and an earlier retirement.
While the 4% rule is just a guide, and history is no guarantee of the future, the simple math outlined above can provide you with a pretty good sense of where you are and where you need to be on your journey towards financial independence and early retirement.