I mention the 4% rule quite often so it’s time we make sure we understand it once and for all.
History of the 4% rule
The 4% rule is usually attributed to the Trinity study (Link to the full study). The Trinity study is a study done by 3 professors from Trinity University in 1998. It used data from 1925 to 1995 and looked at what happened if someone:
- Withdrew different % of their portfolio
- Used fixed/constant withdrawal rate or if someone used an inflation-adjusted withdrawal rate
- Looked at periods of 15-30 years
- Had different mixes of bonds and stocks (shares).
As this blog is about early retirement, I’m going to focus on the conclusions for 30 years as they’re the longest. I’m also going to focus on the conclusions for the inflation-adjusted withdrawal. The reason is that it allows us to maintain our lifestyle. I’ll explain what I mean and put the research question in simple words:
Let’s say we’re testing at a 6% withdrawal rate. If we start with a portfolio of £100,000 we will withdraw £6,000 (inflation-adjusted) every year regardless of if our portfolio went up or down that year. Our withdrawal is not affected by market performance, but we also need to adjust for inflation. If inflation was 2% that year, next year we’ll withdraw £6,120 (£6,000 + £6,000 * 2%). This allows us to keep the same lifestyle regardless of if things now cost more or less.
We do this every year for 30 years and see if we have any money left at the end. However, there are 41 30-year-periods between 1925 and 1995. For We have 1925-1954, 1926-1955 and so on. Then they checked how many of these 30-year periods ended with some money in the bank. Let’s say 32 out of 40 periods ended with money in the bank, that’s an 80% (32/40) success rate.
Credit where it’s due
Before I move to their results and what they mean to us, there is some historical justice to be made. As I said earlier, The 4% rule is usually attributed to the Trinity study. However, they published their research in 1998. A few years before that, in 1994, William Bengen, the true father of the 4% rule published his research called “Determining Withdrawal Rates Using Historical Data” and you can read it by clicking here.
The table below is taken from the original study and shows the results for inflation-adjusted withdrawals.
As I said, I’m only going to look at the 30-year periods as they are the most relevant for early retirees. In our example, we used 6%, the table below shows that with a 6% withdrawal we would have a 68% rate of success with 100% stocks or with 75% stocks/ 25% bond portfolios and a 51% success rate with a 50-50 portfolio. Hope this example helps you understand the table above.
Now look at the 4% column and see why it was chosen as the “Safe Withdrawal Rate” which became the 4% rule. If we had a 100% stocks or 50-50 portfolio, we would get a 95% success rate and if we had a 75% stocks/ 25% bonds portfolio, we would have a 98% success rate! to emphasise how crazy that figure is, consider the fact that the periods used in this study (1925-1995) included the great depression and 2 world wars! Even including these events, a 4% rule still gave you a 95%-98% success rate if you withdraw an inflation-adjusted 4%. That seems pretty damn safe to me. I ignore anything lower than 50% bonds because. Historically, growth came from stocks and bonds are only there to “smooth the ride” in case of market crashes.
While the table above is interesting and clearly shows why the 4% rule became such a consensus, it only shows pass/fail. Enter table 4:
Table 4 shows us what happened to an initial $1,000 portfolio and the terminal (final) amount. If we look at 4% and 30 years, which is the main conclusion of the study we’ll see something truly amazing. We already saw that a 4% withdrawal rate is very safe (using historical data, of course, no one can promise us history will repeat itself). However, look at how much money you’d have left if you withdrew 4% or even 5% a year. Sadly the table did not use inflation-adjusted withdrawals. which would be a bit more meaningful but we’ll work with what we have.
For a portfolio of 75% stocks/ 25% bonds, a withdrawal rate of 4% ended with an average value of 9,031. That’s more than 9 times what we started with! The Median is 8,515 which means more than 50% of the scenarios ended with a terminal amount over 8 times larger than the starting amount.
However, the table is not inflation-adjusted so let’s look at 5% to “compensate” for that. The average terminal value of a portfolio made of 75% stocks and 25% bonds is 7,367. That’s more than 7 times what we started with! The Median is 6,868, that’s just crazy.
Let that sink in. You retire and have no salary, you invest your money in a 75% stocks/ 25% bond portfolio and withdraw 5% (not inflation-adjusted, sadly). After 30 years of no salary, you have a 50% chance of becoming more than 7 times richer than you were when you retired.
Inflation-adjusted terminal values
I don’t know about you, but writing about how inflation-adjusted is the way to go and then using a non-inflation-adjusted table makes my sometimes-OCD mind uneasy. That’s why I have one more piece of data to share with you.
In his book “The simple path to wealth”*, JL Collins includes a similar table to the one above, except it’s inflation-adjusted and uses data from 1926 to 2009 (so even more recent). In that table, he shows that with a 4% (inflation-adjusted, thank god) withdrawal rate, the median terminal value after 30 years is:
$10,075 for a 100% stocks portfolio
$5,968 for a 75% stocks/ 25% bonds portfolio
I feel much better now.
How can we use the 4% rule to plan our retirement?
In the future parts, we’ll look at issues of the study and how we can deal with them. For now, let’s assume we’re happy with the 4% rule. How do we apply it to our retirement planning? There are 2 main ways:
- To set out FI Number
Our FI number is how much we need in order to be able to retire. How much do we need to have invested in order to cover our expenses and not have to work? As we follow the 4% rule, we need our annual expenses to represent 4% of our portfolio. As 100%/4% is 25, we need a portfolio that is 25 times our annual expenses. If you prefer monthly, your portfolio has to be 300 (25 * 12) times your monthly expenses. So just look at your annual expenses, time that number by 25 and that’s how much you need to reach FI.
- To see if you already reached FI
We can also look at it in another way. Look at how much you have invested and time that number by 4%. Could you live on that amount every year? If so, congratulations! you’ve officially reached FI.
Next parts in the 4% rule series
In the next parts of this series (yes, series) of posts, we’ll cover sequence of returns (I’ll explain it, don’t worry) and flexible withdrawal rates. As the periods tested were 1926-1995, we’ll also look at if the results are still relevant.
*I’ve read a lot of personal finance books and “The simple path to wealth” by JL Collins is by far the best one I’ve read. I highly recommend it. It even won a competition ran by Choose FI’s Facebook page for the 30 best personal finance books. It even beat the Choose FI book (on their own Facebook page). You can see some details about the competition (and the other books) here.