The 4% Rule – Understanding the Safe Withdrawal Rate

The 4% rule is a well known framework for retirement planning among stock market investors.

But most people never heard of it or aren’t sure what it represents. And if you’re one of them, this post is for you.

Understanding the 4% Rule or SWR (safe withdrawal rate), starts with asking a simple question:

What Is My Retirement Number?

You’ve likely seen people track their progress toward retirement with statements like “I’m X% to my retirement goal”.

But how do they know that? How do they get to these numbers?

Specifically, X% of what? Million dollars? Becoming rich? I don’t know… Maybe.

But how much money do you think you need to retire on today?

Now, maybe you have a number in mind. However, if you think about the amount in cash, you’re probably wrong (unless you’re close to traditional retirement). Let me explain why the million(s) might not be enough.

Your Savings & Inflation

Let’s say you’re a 20 year old with million dollars in the bank, tax-free. You retire right there and right then.

Even if you inherit a place to live in and are relatively frugal, there is one thing that will make things a little bit more difficult over time. And it indeed seems just a little bit, usually 2-3% each year.

It’s called inflation – the integral part of our economy.

Fast forward when you’re 70… You’re most probably broke, unqualified, and with no pension (because you never worked). Things simply became too expensive for you to keep up over the decades. To put it into perspective, if a 70 year old person had million dollars 50 years ago and just kept them in cash, today they would be worth around $135k (calculated using the CPI Inflation Calculator). That means that the things that costed 1$ when he was 20, cost a bit more than 7$ today.

You don’t notice the consumer price index changing day by day, but decade by decade it becomes way more obvious.

And let me remind you that this is the best case scenario – when the million dollars aren’t touched at all. Pulling money for day to day expenses would deplete the fund even faster.

How to Protect Against Inflation?

There are two ways to protect against inflation:

1. Income
2. Investments

The first one is self explanatory.

People’s earning potential differs, but in most cases, it’s more than enough to live on. Having an income means that you will earn in line with inflation.

But of course, retirement planning revolves under the assumption of not earning an income. That brings us to:

Investing and Retirement Planning

Investing is the only way to conserve our wealth. So, what to invest in?

There are two proven but not risk-free ways: the stock market and the real estate market. For a beginner-friendly introduction to investing, you can check the free series How to Start Investing.

The bottom line is, if one understands these markets, he can have an idea about the expected yearly returns. For example, the annual returns average in the 5-15% range for both asset classes.

So, what does a 5-15% return mean?

It means that your wealth grows in line with inflation, even leaving you with money to spare.

That actually means that you could, theoretically, spend some percentage of your accumulated wealth and… Never run out of money?

Yes.

The 4% Rule

The 4% rule refers to the safe withdrawal rate. It represents the rate at which one can withdraw from his investment portfolio without ever running out of money.

So, why exactly 4% and where did this “rule” come from?

It first appeared in the Trinity Study in Trinity University in San Antonio. In summary, the study backtested a 50/50 stock/bond portfolio against real market data. It showed that a portfolio wouldn’t be exhausted with a 4% annual withdrawal rate in any 30 year period starting from 1925.

So basically, the portfolio’s performance was tracked for every 30 year interval (1925 – 1955, 1926 – 1956, etc.). And regardless of the market’s performance, the portfolio shouldn’t be depleted with annual withdrawal rate of 4%.

A few things about the study I find important:

• The 4% amount is calculated from the initial value of the portfolio, not from the decreasing amounts after the withdrawals each year.
• The initial 4% amount was adjusted for inflation each year, which means it increased with the consumer price index in the subsequent years.

Criticism of the 4% Rule

Of course, past performance doesn’t guarantee future results.

Actually, there are many subsequent studies that prove that 4% is almost enough (i.e. not 100%). Some test for wealth retention instead of staying above zero and others test for extended periods of time.

The paper Safe Withdrawal Rates: A Guide for Early Retirees was a particularly good read. I’d recommend it to anyone who wants to see a more modern perspective.

In other words: there is already a lot of controversy and critique around the 4% rule.

That’s why I’m not saying that the 4% rule is “perfect”, written in stone, or should be taken for granted. However, I am saying that it’s a fair measure to approximate retirement needs before reaching traditional pension age. And of course, it differs based on one’s personal situation, lifestyle, age, spending habits, etc.

For example, a 50 year old and a 30 year old will have a significantly different plans for early retirement.

Also, the 4% rule is a classic, so anyone that invests for the future should be aware of it.

One thing that most studies assume, and rightfully so because it’d be unscientific otherwise, is that all your income will be generated by market returns. However, in real life you may have some extra income, inherit assets, have better performing asset classes in your portfolio, etc.

So your personal withdrawal rate and circumstances should be adjusted accordingly.

Alternatively, my recommendation is to do as I do – learn to love what you do and don’t obsess over financial milestones. And eventually, you might only need less than 1% in yearly withdrawals to sustain your lifestyle. But my personal circumstances and approaches deserve a post of their own.

Your Retirement Number

So, how to calculate your retirement number?

Well, you learned that you can estimate it using a 4% SWR from your investments every year.

That means that you should start by determining your yearly expenses. You can do this by estimating or tracking your monthly expenses, add an overhead for unforeseen situations, and multiply it by 12.

Then, find the number of which 4% equals your annual spending. An easy way to do this is to take your annual spending and multiply it by 25.

For example, if you live on $80k per year, you will need a two million (80,000 * 25) dollar portfolio to retire (early) on.

If you can live on $40k per year, you’d need $1M to retire. If you live on $20k, you’ll need $500k. And if you live on $0, you will need $0.

So, what’s your retirement number?

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