The Many Faces of the Four Percent Rule
If you are a fan of early retirement and financial independence, then you have probably heard of the four percent rule. And if you haven’t, then welcome to the Club and allow me to explain more.
The four percent rule as developed in the “Trinity Study” way back in 1998 says:
a portfolio of stocks and bonds can support four percent annual withdrawals, adjusted for inflation each year, for a period of thirty years with very little chance of running out of money during that period of time.
The four percent rate of withdrawal is often called the safe withdrawal rate because the retirement portfolio didn’t run out of money in 95% to 98% of overlapping thirty year periods of past investment returns dating back almost a hundred years.
The four percent rule says that in the past, four percent was a safe amount to withdraw in almost every case. The inference from the Trinity Study is that if the future is no worse than the past, then it’s likely that four percent will continue to be safe going forward. The Trinity Study didn’t try to predict future returns, but rather came to a conclusion of what would have been safe in the past based on many decades of returns including some horrible periods of twentieth century financial history.
The Four Percent Rule – Fixed Withdrawals Plus Inflation Method
In its classical form, the four percent rule provides a level withdrawal amount each year in real terms. As inflation goes up, your annual withdrawal goes up as well, but only enough to cover inflation. In other words, you’ll have the same purchasing power in year one of retirement as you will in year thirty (and every year in between).
- Consistent withdrawals year after year maintain a steady standard of living
- No need to cut spending during an economic downturn or consider altering one’s lifestyle to reflect poor market returns
- No feedback mechanism in the spending rule means no upward adjustment when the portfolio value increases significantly and no downward adjustment in down markets to conserve assets
- Not a realistic reflection of how retirees actually spend money. Who would feel comfortable spending tons in the face of a market crash? Who wouldn’t spend more after years of sustained portfolio growth?
- “Success” means having $1 or more left at the end of the 30 year retirement spending period (what happens if you live 31 years?). Having only $1 to my name at any point in my retirement would be incredibly scary and I wouldn’t consider that a success in practical terms.
I have always viewed this classical statement of the four percent rule as a useful long term planning tool rather than a form of prescriptive withdrawal strategy to be used faithfully and relentlessly during retirement.
Flip the four percent rule upside down and you get a quick and dirty rule of thumb that tells how much to save for retirement.
Portfolio amount x 0.04 = annual spending/withdrawals
Rearrange the equation and solve for portfolio amount and you get:
Portfolio amount = annual spending / 0.04 = 25 x annual spending
Portfolio amount = 25 x annual spending
You need twenty five times your annual spending in your investment portfolio to have “enough” to retire using the four percent rule. That 25x multiplier is a great way to put the four percent rule to use for planning purposes. Want to spend $40,000 per year in retirement? You need 25 x $40,000 = $1,000,000!
The Other Four Percent Rules – Percent of Portfolio or Variable Percentage Withdrawal Methods
I look at the classical four percent rule with its fixed annual withdrawals (plus inflation) as being more bad than good.
Look, I’m hard core. I’ve got the battle hardened skin to weather a massive blizzard of hurt that the market occasionally snows down on us. In the past year you’ve seen my stoic posts on losing $36,000, $64,000, and even $74,000 in a single month. I just don’t care.
But if those kinds of losses showed up month after month without reprieve (as they did in the 2007-2009 period), I wouldn’t be blindly following the “spend 4% of your initial portfolio value adjusted for inflation” rule. I would be looking for ways to cut spending in order to conserve what’s left of my portfolio. That’s human nature.
The percent of portfolio method and the variable percentage withdrawal method are variations of the traditional 4% rule’s fixed plus inflation withdrawals.
Under the percent of portfolio method, each year you spend a certain percentage of the current value of the portfolio. A safe percentage is 4% for this method. A 4.5-5% withdrawal rate is also acceptable in many cases for older early retirees. For the 4% “percent of portfolio” withdrawal on a portfolio starting at $1,000,000, the annual withdrawal would equal $40,000. If the portfolio goes up to $1,200,000 next year, the annual withdrawal would be $48,000 ($1,200,000 x 0.04 = $48,000). If the portfolio drops to $900,000, the annual withdrawal would be $36,000 ($900,000 x 0.04 = $36,000). It’s simple – the market goes up and you can spend more. The market goes down and you spend less. Under the percent of portfolio method, the annual withdrawal is informed by the actual portfolio value each year unlike the fixed withdrawals plus inflation method which keeps the spending constant in real terms (after inflation).
The variable percentage withdrawal method, a variation on the percent of portfolio method, was developed by the geniuses (I mean that in a non-sarcastic sense) at the Bogleheads site. Instead of using a fixed 4% or 5% withdrawal rate, the percentage withdrawal rate increases each year as you get older to account for a shortened life span (sadly enough, as you get older your life expectancy decreases). A 35 year old’s withdrawal percentage is 4% whereas a 65 year old’s withdrawal percentage is 5% (based on a 60%/40% stock to bond asset allocation). In the intervening years, the percentage withdrawal rate creeps up from 4% to 5% by a tenth of a percent every few years. The variable percentage withdrawal method has the same year to year volatility that comes with the percent of portfolio method, but increases the withdrawal percentage rate over time as the retiree gets older.
There are pros and cons to these portfolio withdrawal methods that reset each year based on the then-current value of the portfolio.
- There is a feedback mechanism to increase spending during good years and decrease spending in bad years
- This change in spending provides psychological comfort. You’re “doing something” to prevent running out of money in a bad market and you’re enjoying the largesse during good times.
- Impossible to run out of money (there will always be 4% of whatever is left in your portfolio, but it might be painfully small)
- You can withdraw a higher starting percentage (at age 35, around 4% versus perhaps 3.25% or so for the fixed plus inflation method)
- As a trade off for being able to spend a higher rate initially, spending may get cut in some years, perhaps drastically
- Unpredictable. Say goodbye to that trip around the world next year if the market tanks tomorrow.
- Annual spending may not keep up with inflation over the intermediate term (in a weak market)
Comparing 4% Fixed Plus Inflation Versus 4% of Portfolio Each Year
Here’s a simple illustration of actual withdrawals someone retiring ten years ago in 2006 would have experienced.
For investment returns, I copied the Vanguard Lifestrategy Growth Fund (VASGX) annual returns. This fund consists of a growth oriented mix of 80% US and international equities and 20% bonds. It’s representative of a typical asset allocation chosen for those investors focused on long term growth.
The ten year period from 2006 to 2015 is a good representative sample of a typical decade of investing. There were a couple of bad years with slightly negative returns, one year of horribly negative returns (down 34% in 2008!), with the remaining years ending in the positive. The market returned an annual average of 5.4% during this ten year period. Inflation was tame at an average of 1.86% per year. In other words, not the best ten year period and not the worst ten year period, but pretty typical as far as decades go in the investing world.
We start with an initial portfolio of a million dollars. Under the fixed plus inflation withdrawal method, the withdrawal in the first year is 4% of one million dollars, or $40,000. In subsequent years, the withdrawal is increased by inflation each year. The 2007 withdrawal is 2.5% higher than the 2006 withdrawal due to the 2.5% CPI-U inflation during 2006. Mathematically, the 2007 withdrawal is $40,000 x (1+ 0.025) = $41,000. In 2008, the portfolio withdrawal is 4.1% higher than 2007 due to the 4.1% CPI-U inflation during 2007.
It’s worth noting that in real terms (after inflation), the withdrawal remains $40,000 per year while the nominal value increases every year to match inflation, ultimately ending at $47,730 in the tenth year. That $47,730 withdrawal in 2015 has the same purchasing power as the $40,000 withdrawal in 2006.
Under the percent of portfolio method, there is no guaranteed increase for inflation each year because the withdrawal amount resets each year based on the portfolio value each year. The initial withdrawal in 2006 is 4% of $1,000,000 or $40,000, leaving $960,000 in the portfolio. Since the market had a banner year in 2006, the $960,000 remaining in the portfolio generated a 16.13% return bringing the account balance to $1,114,848 at the start of 2007.
The 2007 annual withdrawal is 4% of $1,114,848, which equals $44,594. In subsequent years, the annual withdrawal amount is 4% of whatever is left in the portfolio each year. In the early years of 2007 and 2008, the annual withdrawal increases significantly in lock step with the rising value of the portfolio. However after a horrible 34.39% market crash in 2008, the portfolio balance drops to $724,394 and upon calculating the 2009 annual withdrawal, we see the early retiree can only withdraw $28,976!
For the five years from 2009 to 2013 the retiree following the percent of portfolio method actually withdraws less than the $40,000 initial withdrawal back in 2006. However, by 2015 the percent of portfolio method results in a $47,360 withdrawal which is within a few hundred dollars of the 4% fixed plus inflation withdrawal.
Can You Limbo?
How flexible are you? Those middle years from 2009 to 2014 might be troubling if you absolutely have to have $40,000 (in real dollars) to survive every year. However, if you’re okay with the concept of cutting expenses during bad years, possibly even six straight bad years, then you will be okay.
Alternatively, you might not want to cut expenses drastically but instead prefer to earn a little income on the side to support your living expenses. For example, in the worst year of 2009, $7,000 of income from a part time gig or a hobby business will get you to within 10% of the starting $40,000 withdrawal. That plus some minor cost cutting or spending deferral would get you through the worst parts of the recession. I’ve talked about this concept previously when I discussed why I don’t think we’ll ever run out of money in early retirement.
When you limbo, it’s all about how low can you go. For retirement spending, it’s all about your core expenses which is how low your spending can go. For our household, I identified around $24,000 per year in core living expenses. That’s not to say we would prefer to live on $24,000 per year or that we could even do it for many years in a row. That level of spending means no vacations, no new car purchases, and no major repairs to the house (more DIY?).
When I developed my first early retirement budget, I allocated an extra $8,000 per year mainly to cover discretionary spending above the austere $24,000 per year core expenses. In other words, I added the fun and the fun costs $8,000 per year.
More recently as our portfolio grew, I increased our 2016 retirement budget to $40,000 which gets us close to a 4% annual withdrawal rate. Those core $24,000 in expenses are still there, but there’s even more fun in the mix mainly in the form of a fattened travel budget. We may not spend that much this year, but it’s okay if we do.
For planning purposes, you have to establish what your core expenses are and what your ideal budget would be. Those two numbers can help you determine how flexible your annual withdrawals can be. If you aren’t already tracking your expenses, then consider using the free income and expense tracking tools from Personal Capital. That’s how we keep track of our monthly spending.
If you can cut your spending almost in half like we could, then the percent of portfolio or variable percentage withdrawal methods would probably generate higher average withdrawals over many decades without taking on too much risk of depleting your portfolio.
If, in contrast, you have a lot of fixed expenses or don’t want to cut your standard of living in down market years, then the fixed withdrawal plus inflation method would make more sense for your desired lifestyle. It might also mean you need to save more money if you’re planning on retiring in your 30’s or 40’s and planning for five or six decades of retirement. Remember that the classical 4% rule says you can withdraw 4% plus inflation every year for 30 years with a high probability of not running out of money. Extend the withdrawal period to 50-60 years and you’re looking at a safe withdrawal rate closer to 3.25-3.5%.
So far I’ve presented these withdrawal methods as mutually exclusive options. The truth about withdrawal strategies is that they are nothing more than general guidelines for what should work in the future based on past history. In reality, you could choose the fixed plus inflation method to get you through the first five or ten years of early retirement, and then if your portfolio keeps growing, you could switch to a percent of portfolio method to convert some of that portfolio growth into spendable liquid cash and increase your standard of living.
How Do You Actually Withdraw 4% Per Year?
I get asked this question a lot on the blog and in my Early Retirement Lifestyle Consulting sessions, so it’s probably worth covering the mechanics of actually pulling the 4% per year from your investments.
It’s easy to say 4% of a million dollar portfolio yields $40,000 per year in withdrawals. But how do you turn a small chunk of your portfolio into spendable cash in your hand (or checking account)?
Here’s how to create a $40,000 annual withdrawal from a $1 million portfolio that consists of $300,000 in a taxable brokerage account and $700,000 in 401k’s and IRAs:
- $7,500 in dividends/interest from the taxable brokerage account (2.5% dividend/interest yield on the $300,000 account balance). Have these dividends and interest pay to your cash account or transfer to your checking account.
- $32,500 sale of investments. Place an order to sell and transfer the sales proceeds to your checking account.
If you’re under age 59.5 then you should figure out how to access the 401k and IRA funds without paying a penalty. The Roth IRA Conversion Ladder can help you. In this example, the $32,500 sale of investments will probably generate somewhere around $5,000 to $20,000 of capital gains. That amount plus your $7,500 dividend income will put your total income for the year at a level that won’t generate much of a tax bill. You can convert traditional IRA assets to Roth assets without incurring a huge tax liability (but beware falling off the Affordable Care Act subsidy cliff!).
If you choose the Roth IRA Conversion Ladder strategy, as you spend down your $300,000 taxable brokerage account, you’ll be converting traditional IRA assets to Roth IRA assets. Once the taxable brokerage account is substantially depleted, you should have a decent balance built up in Roth IRAs. To fund your future $40,000 annual withdrawals after depleting the taxable brokerage account, you can initiate a withdrawal from your Roth IRA account tax free and penalty free (and keep on converting traditional to Roth).
More on withdrawal strategy and retirement calculators
In case I haven’t quenched your thirsty desire for knowledge of the four percent rule, I’ll refer you to Jeremy at Go Curry Cracker, Mr. Money Mustache, Mad FIentist, and JL Collins who have all done a great job exploring the four percent rule and its workings at their own blogs.
In the coming months I hope to review the major retirement calculators popular in the financial independence / retire early community. Here are those calculators if you can’t wait:
Have you considered a withdrawal strategy for your retirement? Are you a fan of fixed plus inflation or one of the methods based on a percentage of the portfolio balance each year?