The 4 Percent Rule or Safe Withdrawal Rate is a key piece of investing knowledge that I think everyone in the world should be aware of. Especially if becoming financially independent and retiring earlier than the rest of the population are on your agenda.
If you stumbled across this page looking for a quick and exciting hot tip about gold stocks or crypto, then I’m afraid you’re in the wrong place. However, stick around as this long-term investment strategy could still rock your world.
To begin, we need to start with a definition. The Safe Withdrawal Rate can be defined like so:
The maximum rate at which you can spend your retirement savings (annually) without ever running out of money in your lifetime.
This may seem like a difficult rate to calculate and it is almost impossible to calculate exactly. Nobody knows how long you’ll live, what financial markets will look like in the future or a number of other factors. This is where the 4 Percent Rule comes in and is used as a rule of thumb.
The 4 Percent Rule is that, upon entering retirement, you should withdraw 4% each year from the starting value of your retirement savings. This would ensure that you have enough money to live off forever.
The 4 Percent Rule comes from the idea that your retirement savings are invested in stocks or shares (in a tracker fund or something similar) that pay dividends and that their price appreciates on average 7% per year. Accounting for inflation, which is on average 3% per year, that leaves you with the magic 4% left to live off reliably for the rest of your days. You still have the same purchasing power because you account for inflation and 4% remains the steady minimum withdrawal rate to keep the portfolio (your ongoing investments) at a stable level. Your portfolio is growing by an average net 4% each year and you are withdrawing that 4% to live off. It all balances out.
Because you now know that 4% is going to be how much you withdraw each year to live off, you can do a pretty amazing thing: calculate how much money you need (saved and invested) to retire. To do this, simply take your annual spending (roughly if you don’t know it) and multiply it by 25. That’s your retirement target. You might be surprised just how little you need.
If you are pretty frugal and can live off £25,000 per year, you only need £625,000 saved (and then invested in a fund) to retire.
If you live off a healthy £35,000 per year, you would need £875,000 saved.
If you want to live a luxurious life for the rest of your days on £50,000 per year, you would need £1.25 million saved to retire.
As you can see, the less you spend annually, the less you need to retire off. It might be time to revisit that pesky hedonic adaptation topic…
The Trinity Study
If you are pretty rational human being, then you are probably thinking this is a little too good to be true. I mean where in the world have all of these magic numbers been plucked from?
Well in 1998, three finance professors published The Trinity Study which examined this very thing. What is the safe withdrawal rate over a 30 year retirement period with savings invested in a 50% stocks and 50% bonds portfolio? They looked at rolling retirement periods; so 1926-1956, 1927-1957 etc.
Here is a graph showing the findings:
As you can see, if you retired anytime between 1926 – 1981, the safe withdrawal rate never dropped below 4% and even climbed as high as 8%. You could have withdrawn 8% of your savings and still had a growing surplus of cash in your retirement fund!
Some Criticisms of the 4% Rule (and why you should probably ignore them)
There have been some criticisms of this rule, especially in recent years. Some are reasonable while I feel a lot are completely unfounded. It’s time to debunk some of these…
But things will be different (worse) in the future
Of course, things will be different, yet everyone assumes this to be a negative thing. Yes there will be economic issues, markets shifting, industries disrupted. That only matters though if you are a short-term trader. This is a long-term investment which will continue up to and all through your retirement, whenever that may be. The Trinity Study was carried out on an American economy that went through a World War, The Great Depression, a Cold War amongst other things yet you could always reliably withdraw 4% of your investments without affecting future years. This is a fairly concrete number. If you are really, really pessimistic about the future, then 3% will probably be your bulletproof number.
But I am going to be retired for more than 30 years
That’s great and thankfully you’re going to be relatively unaffected. The maths is on your side here because, after 30 years, the length of your retirement barely affects the safe withdrawal rate calculations. Its a bit like the compounding effect when paying off long-term debt like a mortgage. An extra 100-pound payment per month brings the pay off date much, much closer. 100 pound less paid per month means you now may not pay it off for 500 years! The multiplying effect is huge and so a 30-year retirement vs a 60-year retirement is not enough to affect the maths. The 4% still stands.
Why You Should Follow The 4 Percent Guideline
There are other criticisms about the Safe Withdrawal Rate and 4% Rule and I do agree that you may need to make small adjustments when you actually hit retirement with your big pot of money. However, here are some reasons why I think you should be aiming at and saving to achieve that magic retirement number we calculated earlier…
The Trinity Study – What it doesn’t account for
As we saw in the Trinity Study graph, the Safe Withdrawal Rate never fell below 4%. The study also assumed:
- You will never earn another penny through part-time work or self-employment
- You will never receive a penny from social security or a pension plan
- You will never adjust your spending. I.e. you will always spend that £50k a year, even in a recession.
- You will never collect any inheritance from anyone
- You will not spend less as you age (which most people actually do)
There are 5 things that the study doesn’t account for and 4% would still be enough to live off. I know for sure that if I manage to ‘retire’ early then I won’t be sat on my butt doing nothing for the next 40 or 50 or however many years. Extra income means even the 4% might be too conservative but certainly adequate…
Good Habits
You now know that:
- If you save and invest 25 times your net annual living costs, you can effectively retire.
- Withdrawing 4% of that pot each year is enough to live off forever and also counter inflation
- Retirement is probably closer and cheaper than you think
Number 3 especially sets the stage for good habits to start forming.
If you want to know how I tackle this investing malarky, you can check out that section in my passive income post.
If you want to get a little nerdy, you can play around with the retirement calculator from the FIRECalc website. Play around with portfolio sizes, annual spending and years of planned retirement to see how realistic your goals are and to start planning your long, healthy and happy financial future.