What is the 4% rule? It is the magic formula for early retirement. Make your money work for you while you no longer have to work.
If you want to retire way before 65, listen up. This is how you can do it.
What is the 4% Rule?
The 4% rule is a benchmark that can be used to calculate how much money to withdraw from your retirement accounts every year for at least thirty years without depleting those accounts and outliving your money.
In 1994 William Bengen, a financial planner published a study showing the results of testing a number of rates of withdrawal based on historical rates of return. Bengen concluded that 4% was the highest rate that could be withdrawn for at least 30 years without running out of money.
Keep it Simple Silly
The rule has stuck around for so long in part due to its simplicity. A lot of us don’t like math and complicated formulas, and that’s why the 4% rule has been popular. There are no complicated formulas involved. Even the most math or financially unsavvy among us can understand it and use it as the basis of our retirement plan, and we don’t need to pay an expensive advisor to figure it out for us.
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Here’s how the 4% rule works. You withdraw 4% of your retirement money. If you have $500,000 saved, you would withdraw and live on $20,000. But you need to account for inflation too, so you increase the amount of that first withdraw ($20,000) to reflect the impact inflation has on your buying power.
If annual inflation is 2%, the second year of retirement, you take out $20,400. The next year, $20,800, and so on. You continue these 4% withdrawals and the extra amounts to preserve your buying power no matter what the market is doing or how your portfolio is performing. Adding in the amounts to account for inflation will ensure that you have the same purchasing power in your first year of retirement as your last.
Allocate those Assets
Bengen and subsequent researchers currently recommend an asset allocation between 50-75% stocks, as close to 75% as you can tolerate and still sleep at night. That sounds high for retirement, but researchers who study probability in the stock market are more optimistic that stocks will outperform bonds over the long term and give you real returns.
That allocation is a shift from what was recommended in the original study. The initial recommendation was a 50/50 allocation. Twenty years ago the yield on a three-month Treasury bill was 6%. As late as 2002 the five-year US Treasury yield was 4.5%.
But those days are gone. Today a three-month Treasury bill is at a paltry 0.4%, and the five-year yield is an anemic 1.67%. Even your crummy checking account pays better than 0.4%! This is why some people feel the 4% rule had its time and place but is no longer relevant.
A Variety of Variables
The 4% rule is just a rule of thumb and as such, isn’t one size fits all. There are some things to consider if you want to follow the 4% rule for retirement.
The most important variable is having enough money saved for retirement. If you only have $10,000 saved for retirement, and you apply the 4% rule, you would be living on $400 a year which is not enough no matter how many frugal life hacks you employ.
People are living longer than ever, and our money has to outlive us. At the same time, medical expenses are not getting any cheaper so that will be an important part of calculating how much money you will need in retirement. While none of us can know how long we’ll live or how much we’ll have to spend on healthcare, there are some clues.
How long did your parents and grandparents live? Do you have a chronic disease like diabetes or a family history of a chronic disease? If you’re married, look at the same markers for your spouse.
What are your yearly expenses and how much could you cut out if you had to? Where do you want to spend your retirement? In the same high cost of living urban area, you spent your working life or will you move to a much lower cost area?
Will you pay off your home before you retire or will you sell your home and downgrade to a smaller one or maybe rent rather than deal with the hassles of home ownership during your retirement?
If you have a family, do you want to leave them a large inheritance or do you want the last check you write to bounce?
How much of your retirement income will Social Security make up? (We all are aware this may or may not be available to us, and you know the disclaimers, so I’ll spare you all that in this article).
Will you continue to work in some capacity during retirement, maybe part-time or as a consultant?
Remember, retirement doesn’t have to mean the end of work; it just means the end of mandatory work. So don’t plan your retirement party just yet.
Who Doesn’t Like Leftovers?
When most of us consider the 4% rule, we worry that we will run out of money before we run out of years but sometimes, those who follow the 4% rule have large sums of money left over at the end of 30 years.
I don’t see the problem, but I guess some people can see everything as a problem! If you’re worried about this, allow me to ease your burden. You can send me all that leftover money! Now you can rest easy.
If you have a family, and they’re not jerks, you can get all that leftover cash to them. If they are jerks, there are lots of worthy causes that would be happy to have your bequest. Maybe you can get a wing of the Met named for yourself or something,
The 4% Rule or a Real Estate Empire?
Does it Still Apply?
Plenty of people, finance writers, economists, financial advisors, think the 4% rule is outdated. They cite things like artificially low-interest rates and increased market volatility. If the market doesn’t continue to rise over the next few decades the way it has over the last century than the 4% rule may be too risky and a 3% rule would be safer.
Other pundits think that the cost of retirement is being overestimated. Retirement is a time in life when living expenses decrease, and you could be safe using a 5% rule.
Top it Up
The 4% rule as your sole retirement plan is probably outdated. It is still relevant though if you have other resources, you can draw on during retirement. Just like any form of investing, being diversified offers your protection from outside influences that are beyond your control.
Having things like equity built up in your home, rental properties that generate cash each month, a cash value life insurance policy, and manageable living expenses, you can still use the 4% rule and outlive your money.
The 4% rule should not be the sole basis of your retirement plan. It’s too inflexible and too dependent on economic conditions that no one can guarantee. It is, however, a good starting place if you have no idea where to start when it comes to understanding how much you will need for retirement.
The Four Percent Rule: Calculate how much you need to apply the rule.
Betterment: Start investing today.