Ask every aspiring retiree if they have heard of the 4% rule, and they will all tell you “Of course! It’s how much you can withdraw in retirement without ever running out of money, right?”. But few know the details, how safe it really is, and whether it can be flexed.
Would our savings be enough?
This is the (early) retiree’s most dreaded scenario – running out of money. Would we really be able to stop working and retire early without depleting all our savings?
It is this way that we came across the concept of Safe Withdawal Rate, and the ‘4% rule’. This is a topic which is heavily debated in the FIRE (Financial Independent, Retired Early) community. There are lots of contrasting opinions on it, and in the absence of a final answer, we had to make up our mind about interpreting it and using it in our financial calculations. I will share what we make of it; but first, some history.
The story of the “4% rule”
“How much can I safely withdraw from my retirement savings?”. Probably tired of hearing his clients asking this over and over again, an american accountant named William Bengen decided to answer this question scientifically.
In 1994, after analysing lots of historical data, he published a 10-page paper called “Determining withdrawal rates using historical data”. He checked how an investor (with savings invested 50% in shares, and 50% bonds) would have fared for 30 years, if they had retired in January 1926, January 1927 and so on until 1974. He concluded that:
Assuming a minimum requirement of 30 years of portfolio longevity, a first- year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe.
The “4% rule” was born, together with the concept of ‘Safe Withdrawal Rate’.
What about 3% or 5%?
Before deciding that the ‘optimal’ rate was 4%, Bengen checked several other withdrawal rates:
- 3% (or even 3.5%) was found to be an ‘absolutely safe‘ rate, as every retiree would not run out of money for at least 50 years
- 4% would make money last for at least 33 years
- 5% would work in many scenarios, but not all. For example, people beginning their retirement in the late 1960s and early 1970s would only preserve their money for 20 years.
- At 6%, a good 60% of retirees would run out of money before 30 years.
Some important caveats
There are a few things to bear in mind, which are particularly important to early retirees:
- Bengen’s goal was to avoid for the retiree to run out of money within 30 years. Ending with a portfolio worth just $1 was considered a success.
- Tax is not considered in this study, so the income is gross and tax payments may reduce it.
- The assets used are U.S. bonds and shares. Results in other countries could be very different.
- On a more positive note, increasing the portfolio allocation to 75% stocks, instead of 50%, while still achieving the goal of making money last at least 30 years, would increase the chances of reaching 50 years.
The Trinity Study
In 1998, three professors from Trinity University, Texas, published a study (“Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable”) which was very similar to Bengen’s, although it looked at the probability of how long savings would last at a specific withdrawal rate.
Did this study confirm Bengen’s findings? Yes, more or less. According to the Trinity study, a 4% withdrawal rate has a 95% chance of not running out of money in 30 years (which increases to 98% if the portfolio is 75% stocks).
Why 95% instead of 100%, as Bengen found? The difference is probably explained by these two factors:
- The trinity study used longer historical data (from 1926 to 1995)
- The type of assets used is slightly different: Bengen used Treasury Bonds; The Trinity study used Corporate bonds.
Updates to the Trinity Study
In 2009, a researcher named Wade Pfau replicated the Trinity study, using even longer historical data: 1926 to 2009. He wrote:
I think people are sometimes curious if [Trinity’s] result may have changed if the study were repeated today, especially in light of the recent financial crisis. The simple answer is: no.
According to Pfau, the extended data places the success rate of the 4% withdrawal rate at 96%, 1% more then the Trinity study.
In 2011, it was the Trinity’s team turn to update their own research. They confirmed Pfau’s findings (96% success rate for a 4% withdrawal rate), and also increased this to 100% for portfolios which have 75% shares.
So, is the 4% rule really safe in early retirement?
Despite the studies mentioned above, there is still a lot of controversy around the 4% rule, which usually falls in two categories:
- “It’s not safe enough!”, which is the typical objection of aspiring retirees, for whom a 95% probability of success is less than what they would like (a simple, bomb-proof, triple guaranteed 100%).
- “It’s too conservative!”, which is the typical objection of researchers, who believe retirees may end up living a life of sacrifice by limiting withdrawals to just 4% in good years, and would deplete their reserves too quickly by sticking to 4% in bad years. Unfortunately, their suggested solutions are usually of difficult implementation for ‘average’ people.
Bengen himself, updating his own research in 2001, tried to answer both these criticisms by introducing a twist to his own 4% rule. Instead of a fixed 4% withdrawal, he suggested using a variable amount based on the previous year’s market returns. This approach, which he called “Floor and Ceiling” system, would work like this:
- You make your initial withdrawal. Say, $40,000.
- In a bull market, the next annual withdrawal can be 25% higher ($50,000)
- In a bear market, the withdrawals will be 10% lower ($36,000).
- In both cases, the increases (or decreases) are calculated on the initial withdrawal adjusted for inflation.
This approach, according to Bengen, increases the safe withdrawal rate to 4.58% for 30 years. In a recent and very interesting Reddit AMA (Ask Me Anything) he commented:
The average safe withdrawal rate […] is, believe it or not, 7%! However, if you experience a major bear market early in retirement, as in 1937 or 2000, that drops to 5.25%. Add in heavy inflation, as occurred in the 1970’s, and it takes you down to 4.5%.
Bengen also added:
As your “time horizon” increases beyond 30 years, as you might expect, the safe withdrawal rate decreases. For example for 35 years, I calculated 4.3%; for 40 years, 4.2%; and for 45 years, 4.1%. […] If you plan to live forever, 4% should do it.
Just like this one, additional research has been performed around the concept of having rules that determine the withdrawal amount, usually between some high-low boundaries, although the suggested models become naturally more complicated.
For example Guyton, in 2004, suggested using a portfolio of 8 asset classes, to be rebalanced annually, and with withdrawals increasing in line with inflation in the previous years, unless the previous year’s portfolio total return was negative. According to his study, the initial safe rate for 30 years could increase to 4.7% (for portfolios with 65% stocks) and even 5% (for 80% stocks). These rates drop to 4.4$ and 4.7% respectively for 40 years.
The key takeaway for early retirees
The “4% rule” is extremely popular, and for a good reason: it is easy to understand and implement.
The additional points to remember are:
- Lots of researchers have looked into this, usually confirming 4% is safe for 30 years (and if anything, maybe too low).
- Unfortunately there isn’t much research done over extended periods of time (eg the 60+ years we all hope to enjoy 😜), but the one available points to 4% as a safe rate
- 3% is usually considered to be ultra-safe in any scenario.
There is some margin of safety
There are things which apply to the real world which are difficult to model in a research, but can provide a margin of safety for early retirees:
- Circumstances will change during life and the amount of money needed per year may actually reduce with the passing of time (although health related costs may increase that).
- People can find jobs if they hit difficult times, and in particular with early retirees, there is actually an expectation that some additional income will be generated in retirement anyway.
- Research usually assumes inflation based withdrawals. However, instead of increasing their withdrawals, quite a few retirees will tend to stick to the initial amount, and flex their expenses instead. This makes the 4% rule safer.
- Social Security are not considered in these studies. This is obviously conservative for people who at some point may get an extra income from pensions.
- In the age of the internet there are plenty of opportunities for creating passive income. For example, running a blog 🙂
- On the negative side, none of the papers consider tax. This could substantially reduce the net withdrawal rate.
The Family’s take on the 4% rule
With so many things we don’t know about retirement, we take great comfort from looking at numbers. We track our expenses carefully and, probably like every retiree (let alone early retirees) we look for ages at excel files and other calculations to determine whether we have enough to retire. We also try to avoid making these 9 money mistakes.
However, nobody can actually predict the future. We can look for as long as we want at historical data, Monte Carlo simulations and even random scenarios, but these can only provide a partial answer to our questions. No one will ever be able to mathematically confirm their ability to retire with a long time horizon.
For people who are approaching retirement, and even more for the ones considering early retirement, Bengen’s 4% rule is an important rule of thumb and can provide a significant reference point when trying to answer the question ‘When will I be able to retire’?
Having said that, if you find yourself agonising over whether to use 3.75% or 3.82% in your simulations, you probably just have the (understandable) fear of making the jump. The ‘One more year’ syndrome is born our of this fear.
I seriously doubt one will ever feel ready. The more time you take to start your early retirement, the less you have to enjoy it.