3 Lessons You’ll Find in the Four Percent Rule

If you’ve spent any time on retirement planning, you’ve probably heard mention of the 4% rule. It was developed to help determine how much money retirees could safely take from retirement accounts annually, without depleting their funds.

Summarizing the rule quickly, you can withdraw 4% of your portfolio on day 1 of your retirement. You can then withdraw a similar percentage every year thereafter (the actual dollar amount will change based on remaining balances, of course), adjusting the amount to keep pace with inflation. Done properly, you will have very little chance of running out of money.

The 4% rule has been widely accepted in the early retirement community. This is in spite of the fact that early retirees have much longer retirement lengths than the 30-year assumption used in the rule’s original research. Conversely, though, there is credible new research which suggests that in low interest rate environments, as we are currently experiencing, 4% withdrawal rates are too optimistic, even for traditional retirements.

Whether the 4% rule is gospel truth, too conservative, or too aggressive for retirement planning can be debated. However, there are universal lessons hidden in the 4% rule which are valuable to anyone on the path to financial independence and retirement.

Lesson 1: The Fastest And Easiest Path to Financial Independence Is Needing Less

The 80% Salary Replacement Rule is commonly used by financial advisers to determine retirement income needs. According to the 80% rule, what you need for retirement is tied to what you earn in your working years. If you earn $50,000/year, assume that you will need $40,000/year in retirement. If you earn $100,000/year, assume that you will need $80,000/year in retirement.

The 80% rule works for many people because they spend most or all of their income. However, just because many people live this way does not mean we all should.

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The 4% rule disassociates earning and spending. Let’s think of it another way: using the inverse of the 4% rule, we get the rule of 25. When your investments reach 25 times your annual spending, you are considered financially independent. Now, you would have enough money to withdraw 4% of investments and live exactly as you are.

Your spending, not what you ever earned, determines how much you need to be financially independent. This knowledge can be empowering.

Understanding how much you actually need to be financially independent can, at first, also seem intimidating. If you spend $100 monthly ($1,200/year) for cable TV, you would need $30,000 ($1,200 X 25) in investments to support this expense alone. That number can seem large and difficult to attain, and remember: this would support only $100/month of spending.

However, replacing cable with an online service for $10 monthly would cut this annual expense to $120. To support this expense with investments would require only $3,000.

Saving a few dollars a month does not seem like a big deal at first glance. With this different perspective, though, you can see that not only do you save an extra $1,080 each year. This one decision gives the double effect of reducing the amount needed to retire by $27,000. That is a big deal!

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The effects become quite impactful when applying this logic to bigger ticket items. Supporting a $2,000 monthly mortgage payment in retirement would take $600,000 of investments. However, choosing a home you could pay off before retiring would eliminate mortgage obligations.

Quoting financial independence blogger and writer JL Collins, “Financial independence has two aspects: How much you have and how much you need.” Understanding the 4% rule and its inverse, the rule of 25, should make this clear.

Having enough investments to support a high-cost lifestyle is very difficult to achieve, even for very high earners. However, focusing on needing (and spending) less can make financial independence achievable for nearly anyone.

Related: Money Rules to Ensure a Successful Retirement

Lesson 2: Investment Fees Matter

If you are a regular Dough Roller reader, this should not be news to you. It is a regular theme are here. In fact, you can check out the recent post and podcast inspired by this topic.

John Bogle founded the Vanguard investment group based on this concept. He has written entire books explaining the impact of fees on investment returns. While this lesson can be more fully explained in books, articles, and podcasts, the 4% rule allows for a simple back-of-a-napkin explanation.

Imagine that you spend $40,000/year to live. According to the 4% rule, you need to accumulate a $1,000,000 portfolio to sustain that $40,000 annual spending. However, the 4% rule is an academic exercise and does not reflect investment fees.

If you pay 2% annual investment fees, your $1,000,000 portfolio would cost $20,000. This represents half of what you could safely take from your portfolio. This would leave you with only $20,000 for your spending needs, while keeping your initial portfolio withdrawal at 4%. You would actually have to save $2,000,000, double what you would without fees, to provide your initial $40,000 and pay “only” 2% investment fees while keeping your withdrawal rate at 4%.

Read About 7 Ways to Improve Your Investment Returns

If nothing else drives this point home, the 4% rule should. Investment fees matter!

Lesson 3: Many People Give Themselves No Chance At Financial Independence

In a previous post, I discussed the impact of savings rate on wealth building. The post includes a table that shows the relationship between savings rate and the approximate number of years it would take to reach financial independence. What it comes down to? Most Americans do not save nearly enough to even give themselves a viable chance. It’s near-impossible for them to accumulate 25 times their annual spending, which the 4% rule shows we need to be financially independent when investing in stocks and bonds.

Once we have the means to save enough money, there is then the assumption that we can just blindly put money in our 401(k) or hand things over to an adviser with wildly unrealistic expectations. These scenarios are seen everywhere, such as Dave Ramsey’s “12% Reality.” He writes that “you can expect to make 12% on your investments” using “an investment professional” based on “real numbers.” These ‘real numbers’ assume investing 100% in stocks while failing to account for inflation, volatility of returns, or investment expenses. It does not sound like any real world that I am aware of.

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Studies show most investors get substantially less return than the funds they invest in. This occurs because investors make behavioral errors trying to time and beat the market. Adding insult to injury, they pay unnecessary fees and taxes in the process.

While not perfect, the 4% rule gives a realistic expectation of what you can expect to spend living off a portfolio of paper assets, while factoring in real historic returns and accounting for the effects of portfolio volatility. The inverse rule of 25 likewise gives a reasonable estimate of how much money it takes to be financially independent.

If you are using the assumptions of the 4% rule, you should first understand the effects of savings rate on time to financial independence. Be sure you save an amount that gives a legitimate chance at a successful outcome. Otherwise you are dead in the water before getting started.

Next, you should learn to invest in a way that makes these assumptions valid. This means learning about index investing, which aims to deliver market returns while minimizing investment fees and taxes. Even when minimized, these expenses must be accounted for. You should also learn how to avoid the behavioral errors that most investors make that prevent getting market returns.

If you are willing to make an effort to save an appropriate amount and learn to invest in a competent way, the 4% rule can be a very useful tool to help you with your retirement planning. If you are not willing to take the time and effort, the 4% rule is a reality check. It demonstrates that paper assets do not provide a viable path for many people to build enough wealth to become financially independent.

How Will You Use The 4% Rule?

The 4% rule is one of many “rules” found in personal finance. It was developed to determine how much money can be safely taken from retirement accounts annually. You can choose to follow it, modify it, or use a completely different approach for your retirement spending. However, there are some important lessons hidden in the assumptions behind the research that can help everyone that takes the time to understand them as we find our paths to financial independence.

What are your thoughts on the 4% rule and its accompanying rule of 25?

Topics: Personal FinanceRetirement Planning
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12 Responses to “3 Lessons You’ll Find in the Four Percent Rule”

    • Chris Mamula
      Chris Mamula

      John,

      I have read a good bit of Dr Pfau’s work and generally respect his research on SWR which is why I linked it in the intro of the article. However, I am leery of this particular research that you linked sponsored by insurance companies that shows that insurance products can increase the amount of money available to spend during retirement AND increase the amount of money left after death AND simultaneously reduce risks for customers while the insurance companies have the same investment options as individuals AND have to build in profits for themselves. It is a zero sum game. Sure some people will win with insurance/annuity products. However, to do so means that others must lose. Always the insurance company must make a profit. If they don’t then everyone will lose, b/c your money will be gone when you go to collect your benefits.

  1. LUCY MEOWMAN

    You can get 12% a year sometimes, but not by using Dave Ramseys promoted funds or advisor’s. The fee’s are way too high. Better to learn how to invest yourself and REINVEST the dividends.

    • Chris Mamula
      Chris Mamula

      Agree there are ways to get 12%, but with a traditional portfolio of paper investments adjusted for inflation and accounting for volatility it is historically unlikely over time even without fees. Using the Dave Ramsey approach makes it highly unlikely IMHO.

  2. Lawrence C

    What are your assumptions in the 4% rule in terms of your investment asset allocation and rate of return? I would assume as you age, more of your nest egg would be in bonds than stocks, and as a result, a lower rate of return on investments. Would the 4% rule be able to survive with very low bond returns as they are today?

    As somebody who wants to retire at age 40, you would need your investments to last 50 years. What rate of return would be necessary to not run out of money?

  3. I think you misunderstand the 4% rule somewhat. On day 1, you take 4%, then take that $ amount each year thereafter adjusted for inflation, not the same % each year. That is the safe withdrawal rate for a 30 year retirement.

    • Grant- I think you misunderstand. The 4% rule is that every year you take out 4% (thus the rule part). If you follow your logic, as you withdraw 4% the first year and then keep taking out that same dollar amount, it will soon equal 5%, then 5%, etc. The 4% rule is such that as your amount reduces, the 4% that is withdrawn reduces as well.

      • Chris Mamula
        Chris Mamula

        Actually Grant is correct. I took a look at the intro. The way that was written is confusing.

        Paul, you are not accounting for growth in a portfolio. You are correct that if you are not getting adequate growth (or worse your portfolio is going down in value) that you will potentially take greater than 4% in a given year. If this happens early in your retirement, it can destroy your portfolio. See the link in the final section about the “effects of portfolio volatility”. It is also why a portfolio of 100% “safe” bonds will fail over 30 years almost every time, while a very “risky” portfolio of 100% stocks historically will almost always succeed with the 4% rule.

        • Here’s a good example for a $100K portfolio and 3% inflation. Withdraw $4000 the first year, then $4120 the second year, and so on. If the portfolio earns at least 3% a year, the balance will never go to zero.

          • It’s also interesting to note, that the RMDs for 401Ks/IRAs approximate the “4% Rule.” Starting at age 70.5, the initial RMD is about 3.5% and then it increases by 3% a year for the first five years and a little more after that.

  4. Chris, since I’m assuming from what I’ve read on your website that your goal is 50 years of retirement (at age 40), what are your assumptions for the 4 percent rule in terms of asset allocation and expected rate of return that would enable your nest egg to last that long? Curious because bonds have been so low and would assume as you age, less of your portfolio would be in stocks. Would bonds yielding very low rates be able to support this rule?

    • Chris Mamula
      Chris Mamula

      Lawrence,
      First a couple of quick disclaimers that I am not qualified to advise you on your decisions and I have no idea what rates of return I’ll get over any period of time. That said, I’m happy to share how I personally approach these issues.

      I agree with bonds being a bad bet with low interest rates. I therefore limit my total allocation of cash and bonds to 20%, with 80% in stocks. I also worry about lower than normal returns in the near future (next 10-15 years) for stocks as they are also overvalued by historic standards. We are mitigating this risk by planning to have some part-time income at least early in retirement, and maybe indefinitely. By keeping withdrawal rate to 2-3% we can live off of dividends and interest even in these challenging times without touching principle.

      Hope that helps.

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