“This whole financial independence story might sound nice and dandy, but how will I ever get there?” I hear you think. “How much money do I need to retire?” and most importantly: “What can I do NOW to make sure I get (and stay) on track to reaching my financial goals?”. Well, I am glad you asked as it is about time that we start looking at putting together a lifetime plan for your financial journey that will make sure you reach your financial dreams and that will give you the motivation and blueprint towards achieving those goals.
In order to get that plan together we will first discuss the 4% rule, a hugely popular and helpful guideline to planning for retirement.
The Trinity Study
In the late 90s and then again in 2009, three professors from Trinity University conducted a now famous study on how different withdrawal percentages affected various retirement portfolios over a 30 year period.
What they calculated in particular was how the portfolios stood up against various withdrawal rates, i.e. whether the portfolios would stand the test of time and outlive the withdrawals. If a withdrawal rate succeeded it meant there was still money left over in the portfolio after the time period of withdrawals ended. Their studies included:
- Different withdrawal rates from 3% annually (0.25% monthly) to 12% (1% monthly);
- Pay-out periods of 15, 20, 25 and 30 years;
- Portfolios with a stock allocation of 0%, 25%, 50% , 75% and 100% with the remaining part allocated to bonds;
- The additional effect of adjusting withdrawals for inflation;
- Withdrawal periods between January 1926 – December 2009
The results of their studies included to following:
- keeping 75% stocks and 25% in bonds produced the best results for withdrawal rates up to 6% for inflation adjusted withdrawals. For higher withdrawal rates, the 100% stocks portfolios performed better.
- If you want to keep up with inflation and increase your withdrawal rate, start with a much lower initial withdrawal rate to increase the chance of success.
- Even if you keep up with inflation and adjust withdrawals accordingly, if you start with an initial withdrawal rate of 4%, your portfolio has the following success rates:
- 100% stocks / 0% bonds: 100% success rates for pay-out periods of 15, 20 and 25 years. For 30 years the success rate is 98%.
- 75% stocks / 25% bonds: 100% success rates for all pay-out periods.
- 50% stocks / 50% bonds: 100% rates for pay-out periods of 15, 20 and 25 years. For 30 years the success rate is 96%.
- 25% stocks / 75% bonds: 100% rates for pay-out periods of 15 and 20 years. For 25 years the success rate is 95%, for 30 years it is 80%
- For a 100% bonds portfolio the rates quickly decrease from 100% (15 years) and 97% (20 years) to 62% (25 years) and 35% (30 years).
- Stick to a 3% withdrawal rate and even after adjusting for inflation, you have a 100% success rate in pretty much all scenarios with the only exception being a 30 year withdrawal period for a 100% bond portfolio.
The 4% Rule
To recap: Based on these results one can conclude that if you stuck to a 4% withdrawal rate and you had anywhere from 50% – 100% of your portfolio in stocks, there was a 96% chance minimum that your portfolio would survive the 30 year or less pay-out period in the period between 1926 and 2009. Stick to 3% and your portfolio would almost guaranteed outlive you. (Note how it says ALMOST guaranteed! Nothing is certain, especially not on the stock market of course. Past results are of course no guarantee for future results and the 2007 – 2009 market downturn will have significant effects on the survival rate of portfolios of anybody who withdrew from their portfolio during that time.).
Now what exactly happened to these portfolios over time with these withdrawal rates. Surprisingly enough, if you stuck to a 4% withdrawal rate, corrected for inflation and continued withdrawing even for 30 years, the portfolios still saw huge increases in their value and beating even a 3% average yearly inflation! Assuming a $1,000,000 initial portfolio value and 4% withdrawal rate, after 30 years the value of these portfolios were:
- 100% stocks / 0% bonds: $10,075,000
- 75% stocks / 25% bonds: $5,968,000
- 50% stocks / 50% bonds: $2,972,000
- Only for portfolios with a lower stock allocation, the value after 30 years would have been less than the original value of $1,000,000.
How to guarantee the success of a 4% withdrawal rate
4% is commonly referred to as the Safe Withdrawal Rate. It means that if inflation is 2-3% and the market goes up by 7%, you can spend the remaining 4% freely without your investments losing value. Does this always hold up? Of course ever situation is different and what is important to check is your own situation. Do you expect to have some big lump sum expense coming up (a child going to college, a new car or the buying of a second house), then of course if you are planning on pulling this money from your investments then the 4% rule will also be affected. Equally if you live in a country or state where your wealth is taxed, or where withdrawals are taxed, then you have to take this into consideration. Other than that, the 4% rule is a pretty safe bet.
Take the following points into consideration as well that will help you determine whether the 4% withdrawal a safe guarantee for future income:
- Will you at some point also get social security or other pension payments that might allow you to scale down your withdrawal rate?
- Might you still generate some income after retirement age in other income streams or even part-time work?
- Can you easily adjust your spending patterns in times of a recession? If you can easily decrease expenses then sticking to the 4% even during a market downturn, shouldn’t be a problem.
Step 79 – the 4% Rule – in detail
- In order to calculate your portfolio needs, first decide what percentage withdrawal rate you feel comfortable with. Do you want to stick to the good old 4% or would rather play it even safer and stay on 3%? Do you feel you’ve got enough other sources of potential income of safety net to take a risk and up the amount and go for a 5% or even 6% rate? Decide on what you feel comfortable with and the risk you want to take.
- Calculate your annual expenses and if you want to go for a 4% rule, times that amount by 25 to find out how much you need. Alternatively divide your annual expenses by 0.04 and it gives you the same mount. If you want to go for a safe 3%, divide your annual expenses by 0.03.
- If you expect your annual expenses to go up or down significantly, then take that into account too and adjust your predicted annual expenses accordingly.
- Remember the above calculation does not take inflation into account. If you are still 30 years away from retirement, then you need to take into account that an annual expense amount of $40,000 today will be almost $84,000 in 30 years at an inflation of 2.5%, meaning you wouldn’t need $1,000,000 but $2,100,000 in your portfolio to retire, withdraw 4% and live the same lifestyle.
The 4% rule is one of my favourite steps in financial planning if you are planning on using your investments as a retirement income or as a supplement to your current income at some point.
Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.