What is the 4% Rule?

The 4% rule and its findings are critical to the success of the FIRE principle and understanding it is the key to being able to retire much earlier than you thought.  I will try to give you a clear explanation of what the 4% rule is and how it can be applied to your life.

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4% in a nutshell

The 4% rule is basically the rule that tells you how much you can withdraw from a investment portfolio and expect it to keep its current value.  It is derived from two other numbers found out there in the economy that have shown to be the averages for the expected rate of return on investments and the average inflation rate of the economy.

Rate of Return- how much money you make from the growth of your stocks/bonds and the money they payout in dividends.

Inflation- the growing cost of stuff ie. how a candy bar used to be 50 cents in 1995 and now costs a $1.25


On average it has been found that the return on investment for the general economy is 7%.  This does not mean individual picked stocks but is instead the growth rate overall for the whole economy.  

During this same period of time the average inflation rate is 3%.  So by doing a little bit of simple subtraction of you arrive at a sustainable withdrawal rate of 4%.

This idea has been back up by something called the Trinity Study which showed that over a 30 year retirement if you only withdrew 4% of your portfolio every year that your money has a 96% chance of lasting the whole time.  

But now you might be saying to yourself only 30 years what if retire when I'm 40 is my money going to run out when I’m 70.  

The simple answer is no because of a couple extenuating factors.

1. If you retire at the age of 40 do you really think you are not going to make another cent the rest of your life.  No you are going to end up doing things just to avoid boredom and I would bet that some of those things will make you money.
   
2. The Trinity Study does not take into account social security, pensions or other forms of retirement income that kick in once you reach a certain age.  You could very well end up with a fully funded retirement without having to even touch your portfolio once that money starts coming in.
   
3. In  most years the economy actually grows by more than 7% so if you are only withdrawing 4% the extra income is being reinvested which causes your portfolio to grow.
   

While the 4% rule is powerful the key to really making money lasting a lifetime is flexibility.  If the economy tanks for a year or two and your return on investments is low you might have to cut expenses or get a part time job.  When the economy is booming at 8,9 or 10% that would be a good time to go on a nice long vacation or buy some rental property that can provide you with another source of income.  


Moral of the Story

The 4% percent rule and it should really be called a 4% guideline is something to give you a target to shoot at with your saving and investing.  It is not something that you need to live or die by but instead use it as a benchmark to refer to when making your financial decisions.

 



Further Reading

http://www.mrmoneymustache.com/2012/05/29/how-much-do-i-need-for-retirement/

https://jlcollinsnh.com/2012/12/07/stocks-part-xiii-withdrawal-rates-how-much-can-i-spend-anyway/

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