The 4% Rule Demystified

Hor ki chalda,

"Mandeep, what's that gibberish?" That's Punjabi for "Hi, how are you?" I thought I'd inject a little bit of my culture into these posts. 😊

Lots of people talk about the 4% rule, especially in the FIRE (financial independence retire early) community. 

IMO, these are the last people that should be using the 4% rule. 

Why?

Because the 4% rule was not intended for an early retiree audience. Let’s go over the origin of the 4% rule, which comes from the Trinity Study (more correctly, from Bill Bengen’s SAFEMAX rate). The Trinity Study, which was done by three professors of finance at Trinity University in Texas, simply popularized the research that was first conducted by William (Bill) Bengen. The 4% rule is also called Bengen’s rule, which is a rule of thumb. It is an estimation; it is not a law, like Sir Isaac Newton’s Laws of Motion. 

The importance of this last statement cannot be overstated.  

Let’s dive in and talk about the specifics of the 4% rule. 

The table above is from the Trinity Study (linked out above). I drew a red box around the 95. So let’s look to the left of the 95 and to the top of the 95. 

Essentially, this means that if you withdraw 4% from your portfolio per year, there is a 95% chance that your portfolio doesn’t go to zero over a 30 year retirement period (time horizon) if you hold a portfolio that is 50% stock and 50% bond from a period ranging from 1926 to 1995, AFTER adjusting for inflation.

In popular media, the 4% rule says something like, if you have a $2,000,000 portfolio, you can withdraw 4%, or $80,000 per year without much worry. However, since you read this blog, you now know this only applies to the fixed inputs stated above in the Trinity study.

These inputs/outputs are:

• 50% stock and 50% bond portfolio

• 30 year retirement period

• 4% withdrawal

• 95% chance of inflation-adjusted portfolio success

However, there are a few problems with the 4% when it comes to early retirees.

1. Early retirees are not retired for 30 years; they may be retired for 40, 50, or 60 years. In this case, that 95% chance of success goes WAY down.

2. No one withdraws exactly 4%. During down markets, people typically draw down less, and in bull markets, people may feel comfortable drawing down more.

3. Past historical data is not a guarantee that future rate of return will be similar. It probably will be, but it could also not be.

So, if not 4%, what is a safe withdrawal rate (SWR)? Well, people much smarter than I am have gone to great lengths to explore this. BigERN over at earlyretirementnow.com has a 60 part series - on safe withdrawal rates alone.

One tool you might consider is Vanguard’s Monte Carlo Simulation tool, which you can run here. You can put in your own time horizon, portfolio allocation, and withdrawal rate to get an estimated success rate. But again, this is just a fun tool; the outputs are not a hard-and-fast rule.

If you have fixed income, like Social Security or rental property income/other income streams, this can offset your withdrawals (and withdrawal rate) during market down-turns. It probably isn’t a bad idea to get started on this early in your career. If you’re looking to get into rental property investing, you may want to check out this post here.

While this is one important piece of the puzzle, it's important to have a strong foundation in personal finance education. How can you get all of the battle-tested, tried and true knowledge as quickly as possible? I wrote a book explaining exactly this; it's short; it's 99 cents, and it's written in plain English. You can find it here: https://www.amazon.com/Tangibles-Six-Figure-Millennials-Personal-Building-ebook/dp/B09M6PSBGK/. You may also want to consider subscribing to this blog by entering your email on the homepage next to the “Never Miss a Post” section and following the podcast “Nondelusional Investing” wherever you get your podcasts.

Is there anything you found useful or that I missed above? If so, please leave a comment in the comment box below.

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Best,

Mandeep