What is The 4 Percent Rule?
The 4% Rule, also known as the Safe Withdraw Rate (SWR), is a framework that financial planners and retirees use to determine how much of a stock portfolio can be spent each year without ever running out of money.
How Does The 4 Percent Rule Work?
The 4% Rule is based on two financial averages.
First, the 4 Percent Rule says that your stock portfolio will grow at an average rate of 7% annually. Second, because the average rate of inflation is 3%, you can safely withdraw 4% of that growth, leaving 3% behind to keep up with inflation.
Because you’re only spending the average incremental growth from your portfolio, in theory you should never run out of money.
Origins of The 4 Percent Rule
Credit for developing The 4% Rule belongs to William (Bill) Bengen. In 1994 Mr. Bengen published a 10 page report in The Journal of Financial Planning titled Determining Withdrawal Rates Using Historical Data.
In his report Mr. Bengen looked at historical stock market performance using rolling 30 year periods to create ‘historical simulations.’ During each simulation Bengen determined the maximum sustainable withdrawal rate.
Finally, Bengen identified the worst ‘historical simulation’ (it occurred in 1966) and determined that the safest, maximum withdrawal rate during that period was 4.15%.
The 4 Percent Rule and Early Retirement
The 4% Rule has been embraced by the FIRE movement. FIRE is an acronym that stands for Financial Independence, Retire Early and some people are retiring as soon as their early 30s and 40s. This means their stock portfolio will need to last significantly longer than that of a traditional retiree.
Will the 4 Percent Rule hold up for that long?
Downsides of The 4 Percent Rule.
The 4% Rule originally assumed a traditional 30 year retirement period. How then does it hold up when an early retiree uses the the rule to build a retirement that could last double that time? Turns out, with a bit of flexibility, The 4 Percent Rule holds up just fine.
For one thing, the original study assumed that a person would ALWAYS withdraw 4% from their portfolio, never adjusting their spending during up and down times. That’s not a good reflection of what actually happens (retirees tend to spend less).
The study also assumed that a person would never again add one cent to their portfolio. But many retirees have other sources of income (like Social Security, a spouse that’s still working, income from another business) to help take some of the pressure off their portfolio.
Something called the ‘Early Sequence Of Returns’ is the biggest risk to a retirement plan that’s based on The 4% Rule. Simply stated, if a retiree suffers a market dip during their first few years of retirement, then not only is their portfolio down from the market dip, but it’s also down from their spending 4% of the portfolio.
Digging out of this hole is difficult, even when market gains return. This is called the ‘early sequence of returns risk’ and it could have a bigger impact on your portfolio than anything else (see the ‘further reading’ section below for more on this important topic).
Does the 4% Rule Work?
In a word, yes. While nothing is certain, the The 4 Percent Rule is an excellent rule of thumb for traditional and early retirees alike.
A person can greatly increase the odd of their portfolio surviving by supplementing it with income from other sources such as Social Security, rental property income, or profits from a business or side hustle.
Further Reading Material For The 4 Percent Rule
There is a plethora of quality articles, podcasts, and blog posts on this topic. These are some of our favorites:
- William Bengen’s SAFEMAX, by Dr. Wade Pfau
- The Trinity Study and Portfolio Success Rates, by Dr. Wade Pfau
- What Happens If You Outlive Your Safe Withdraw Rate Time Horizon?, by Michael Kitces
Books On The 4% Rule and Safe Withdrawal Rates
There are also a few quality books you can purchase on this topic (one from Mr. Bengen himself). They are:
- Conserving Portfolios During Retirement, by William Bergen (creator of The 4% Rule)
- The 4% Rule and Safe Withdrawal Rates in Retirement, by Todd Tresidder
- The Simple Path to Wealth, by Jim Collins