One Rule to Rule Them All
You might have heard the rule of thumb that “you should aim to retire with 70% of your pre-retirement salary” or similar.
Rules like that don’t take into account your spending and are too vague to be useful. What if you get a big salary bump in your final year, does that mean you need now need to work longer to meet that 70%? Is that 70% pre-tax, or after-tax? In short, these type of rules sell magazines but are ultimately useless. We can do better. Try this rule on for size:
You need 25 times your annual expenses to be financially independent.
In other words, you can withdraw 4% of an initial investment portfolio. It’s that straight-forward. If you want an annual income of $40,000, your FI number should be $1,000,000. Need $20,000 a year? Your FI number is $500,000.
Where does the 4% rule come from?
The colloquially named Trinity Study was conducted at Trinity University in 1998 in an attempt to determine a portfolio’s safe withdrawal rate (SWR). In the study, the researchers tried to figure out the amount of money that you can take out from a bundle of investments each year without running out of funds. They tracked different investments over a 30-year period while withdrawing a set amount each year and if there was money left after 30 years, that withdrawal rate was deemed a success. The famous study spawned a rule of thumb—known as the 4% rule—and launched renewed academic interest into studying retirement planning and safe withdrawal rates (“SWR”).
The portfolio tested above on cfiresim.com shows an over 95% rate of success with the following parameters:
- 1 million dollar starting portfolio and 40K annual spending (4%)
- 115 simulations of 30 year periods starting in 1871
- 60/40 split of stocks/bonds using historical returns
In the simulation, each line represents a start of the withdrawal stage. There are 115 years that were tested, so there are 115 lines on the chart. Each line begins with a balance of one million dollars on January 1st of its respective year. It is then thrown to the mercy of financial returns of days past and is subject to yearly withdrawals of $40,000. When reading the charts from cFIREsim, it is less important to look at any specific line than it is to follow the volume of lines above and below $0, and the volume above and below the starting value of $1 million.
Don’t forget to model your own withdrawal simulations on www.cfiresim.com! It’s incredibly customizable. I’m a big fan of the ‘variable spending plan’ option. It turns out that adjusting your spending even slightly downwards during a recession can have a profound impact on your portfolio’s success rate.
Is the 4% rule perfect?
No! The Trinity Study was a white paper, and like most white papers it evaluated academic circumstances that are not realistic for everyday investors. The Trinity Study assumed you:
- Would never earn another dollar in your life after you start withdrawing from your portfolio
- Would spend the same amount every year with no possibility of decreasing spending
- Would never receive payments from the Canada Pension Plan, Social Security, or other government programs
For most people, at least one of the above will not be true during the withdrawal stage of financial independence.
Is the 4% rule good for anything?
Absolutely – It’s a great starting point. When the Trinity Study was first published, stocks were flying high in the 90’s and people thought the bull run would last forever. A 4% safe withdrawal rate was mocked as overly conservative by Wall Street traders.
Now, 4% is viewed by naysayers as too risky; some fearful investors are moving towards a safer 3.5% or 3%. This can have a profound impact on the number of years it takes for you to achieve FI, all for a few extra historical success percentages in simulations.
The best course of action is likely in between these two extreme perspectives: A 4% SWR is a reasonable goal if you’re willing to be more flexible and realistic than the model portfolios analyzed in the Trinity Study.
There’s a lot more to cover on the topic of safe withdrawal rates. I’ll update more blog posts here as they’re written:
- The number one risk to your financial independence
- Why using a lower safe withdrawal rate is a bad idea