The 4% Rule: The Easy Answer to “How Much Do I Need for Retirement?”
As with all things financial, it’s the subject of plenty of controversy, and we’ll get to that (and then punch it flat) later. But for now, for those new to the concept, let’s define the Safe Withdrawal Rate:
The Safe Withdrawal Rate is the maximum rate at which you can spend your retirement savings, such that you don’t run out in your lifetime.
That sounds nice and simple, but unfortunately it’s an unpredictable thing to nail down. After all, you don’t know what sort of rollercoaster rides the economy will take your retirement savings on, and you also don’t know what rate of inflation will persist through your lifetime. Will a box of eggs cost $6.00 a dozen when you’re 65, or will it be closer to $60? How can we possibly know how much money we will need to live on in retirement?
The answers you get to this question vary widely. Financial beginners (about 95% of the population) tend to randomly just throw out a number between 5-100 million dollars. Financial advisers who aren’t Mustachians will tell you that it depends on your pre-retirement income, (with the implicit assumption that you are spending most of what you earn) and the end answer will be somewhere between 2-10 million.
Financial Independence enthusiasts will have the closest-to-correct answer: take your annual spending, and multiply it by somewhere between 20 and 50. That’s your retirement number. If you use the number 25, you’re implicitly using a 4% Safe Withdrawal Rate, which is my own personal favorite number.
So where does this magic number come from? At the most basic level, you can think of it like this: imagine you have your ‘stash of retirement savings invested in stocks or other assets. They pay dividends and appreciate in price at a total rate of 7% per year, before inflation. Inflation eats 3% on average, leaving you with 4% to spend reliably, forever.
I can already hear a chorus of whines and rattling keyboards starting up, so let’s qualify that statement. That’s the idealized version. In reality, stocks go up and down every year, and so does inflation. Over a long multi-decade period like the gigantic retirement you and I will be enjoying, enormous things have happened in the past. The Great Depression. The World Wars, Vietnam, and the Cold War. The abandonment of the gold standard for US currency and years of 10%+ inflation and 20%+ interest rates. More recently, the great financial crash and a slicing in half of of real estate and stock values.
If you happened to retire in 1921 on a mostly-stock nest egg, you would have experienced an enormous stock run-up for the first eight years of your retirement. You’d be so rich by the time the 1929 crash and the Great Depression hit, that you’d barely notice the trouble in the streets from your rosewood-paneled tea room. On the other hand, if you retired in early 2000 while holding stocks, you saw an immediate and huge drop in your savings along with low dividend yields – and your ‘stash may be looking pretty sparse today, 12 years into retirement.
In other words – the sequencing of booms and crashes matters. Ideally, you want to retire in a time of low stock prices, just before a long boom. But you can’t predict these things in advance. So again, how do we find the right answer?
Luckily, various Early Retirement Ninjas have done the work for us. They analyzed what would have happened for a hypothetical person who spent 30 years in retirement between the years 1925-1955. then 1926-1956, 1927-1957, and so on. They gave this imaginary retiree a mixture of 50% stocks and 50% 5-year US government bonds, a fairly sensible asset allocation. Then they forced the retiree to spend an ever-increasing amount of his portfolio each year, starting with an initial percentage, then indexed automatically to inflation as defined by the Consumer Price Index (CPI).
This gigantic series of calculations was called the Trinity Study, and since then it has been updated, tweaked, and reported on, recently by a guy named Wade Pfau. He created the following very useful chart showing what the maximum safe withdrawal rate would have been for various retirement years:
As you can see, the 4% value is actually somewhat of a worst-case scenario in the 65 year period covered in the study. In many years, retirees could have spent 5% or more of their savings each year, and still ended up with a growing surplus.
This brings me to a critical point: this study defines “success” as not going broke during a 30-year test period. To people like you and me who will enjoy 60-year retirements, that would not be successful – we want our money to last much longer than 30 years. Luckily, the math in this case is pretty interesting: there is very little difference between a 30-year period, and an infinite year period, when determining how long your money will last. It’s much like a 30-year mortgage, where almost all of your payment is interest. Drop your payment by just $199 per month, and suddenly you’ve got a thousand-year mortgage that will literally take you 1000 years to pay off. Increase the payment by a few hundred, and you have a fifteen year payoff! In other words, above 30 years, the length of your retirement barely affects the safe withdrawal rate calculations.
So far, we’re liking the 4% rule quite a bit, right? But yet whenever I mention it, I get complaints. Let’s review a few of them:
- The trinity study is based on a prosperity anomaly: the United States during its boom years. You can’t project good times like that into the future, because we’re just about to enter the Doom Years!
- Economic growth and stock appreciation was all based on cheap fossil fuels. How will this all look after Peak Oil hits us!?
- You can’t take a one-size-fits-all rule and apply it to something as varied as an economy and an individual’s life! My health care costs could go up! Hyperinflation could strike!
- Even at a 4% withdrawal rate, there’s still a chance of portfolio failure. That means I’ll be flat broke and out on the street in my old age. I recommend doubling your savings, and going for a 2% SWR instead because there’s never been a failure in that scenario!
- This is all wrong! Waaah, waaah!
That’s all well and good. While there are solid economic analyses that I believe can out-argue the points above, I’m not patient or clever enough to re-create them here. Pessimists are free to enjoy their pessimism and even write about it on their own blogs.
Instead of debating unprovable points like those above, we can completely squash them with our own much more powerful list of points:
The trinity study assumes a retiree will:
- never earn any more money through part-time work or self-employment projects
- never collect a single dollar from social security or any other pension plan
- never adjust spending to account for economic reality like a huge recession
- never substitute goods to compensate for inflation or price fluctuation (vacation in a closer place one year during an oil price spike, or switch to almond milk in the event of a dairy milk embargo).
- never collect any inheritance from the passing of parents or other family members
- and never do what most old people tend to do according to studies – spend less as they age
In short, they are assuming a bunch of drooling Complete Antimustachians. You and I are Mustachians, meaning we have far more flexibility in our lifestyles. In short, we have designed a Safety Margin into our lives that is wider than the average person’s entire retirement plan.
So now that we’re feeling good about the 4% rule again, let’s bring the point home:
Far from being a risky proposition, assuming 4% Safe Withdrawal rate is actually the most conservative method of retirement saving I could possibly recommend. To apply it in real life, just take your annual spending level, and multiply it by 25. That’s how much you need to retire, at the most. A $25,000 spender like me needs $625,000. I’ve got more than that, plus various safety margins in the lifestyle, so all is good.
Without undue risk, and as long as you have skills that can be used to earn money eventually in the future (hint: you do), I can even advocate an SWR of 5%. In other words, get your expenses down to $25k, and you can quit your job on $500k or less. Then you can use the methods described in First Retire, then Get Rich to gradually increase your safety margin (and effectively decrease your withdrawal rate) as you age.
So there’s no need to debate. 4% is a perfectly good answer, which means 25 times your annual expenses is a perfectly good goal to save for. Along the way, you might find your annual expenses melting away, which makes things ever-more-attainable (as shown in the shockingly simple math behind early retirement post). But worry, you must not.
And if you’re ready to play with the numbers even further, check out FIREcalc website. It’s basically like owning your own Trinity Study machine, except you can tweak variables (look at the tabs at the top of the page). In the link provided, I used this data:
- 500,000 portfolio
- 25,000 annual spending (5% withdrawal rate).
All alone, a plan like that over 60 years of retirement only has a 45% success rate, historically speaking.
But if you make adjustments which include:
- $8,000 per year of social security starting about 25 years from now
- “Bernicke’s Reality Retirement plan” of dropping spending slightly with age
- Just $3,000 per year in fooling-around income
You’re already at an over 90% success rate. Another hundred or two dollars per month and you have a 100% chance of success, even without invoking many of my other bullet points above.
So that, at last is the long-awaited Safe Withdrawal Rate article.
In the hands of financial infants, the rule is dangerous and scary. But in the hands of Mustachians, nothing is scary. Planning for a 4% withdrawal rate is a shiny, bulletproof limousine of a retirement plan and you can ride it all the way to the party at Mr. Money Mustache’s house.
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