All of us have noticed this recent trend where people talk about getting rich quick and retiring early and online “gurus” who talk about making money while not working and what not. Some of us might have also seen cases where people live off the investments they’ve been handed down from previous generations and so don’t have that need to work. I’m almost 100% certain that each and every one of us have thought about such a life where we retire early and have enough money to last us till the end. But what if I told you that this is possible for all of us to achieve. Sounds impossible? Well read on and find out how.
Meet the 4% Withdrawal Rule. According to this rule in its simplest sense, if you plan ahead and calculate the right amount of money that you need to invest, and then withdraw 4% of that portfolio every year (adjusted for inflation), then you can retire if you’re able to build that portfolio.
Let me walk you through a quick example to explain what this means.
Say you want to retire at the age of 50 and you expect that you’ll live up to the age of 80. Now this rule says that you should find out how much money you’ll need every year for your expenses and that should be 4% of your investment. So if you want $200,000 every year for spending, then $5 million (200,000 dollars / 4% ) is how much money you need to invest. This investment will then help you have money every year till you’re 80 years old. The chart below shows what your annual spending will look like if you’re retirement fund has $1million and the costs increase by 2% a year (inflation)
To break it down into the simplest form, look at the chart below. It shows what the rule explains as withdrawals from an initial portfolio, for a 10 year period.
Now that you’ve got what this rule is about, let’s look at the history of the rule and how it came into being. Bill Bengen, a financial adviser from Southern California first developed the rule considering the returns of Stocks and Bonds as two investment avenues and their returns from 1926 – 1976, focusing on what the worst case scenario could be. He also calculated what would’ve happened if someone retired every year at the worst possible moment, which is basically the time when markets are at their maturity and take a nosedive from the day you retire.
His findings led him to conclude that historically, there is no reason to believe that having a well-constructed portfolio and withdrawing 4% every year wouldn’t last at least 33 years. Bill Bengen did not stop with these findings, and has since then performed multiple other studies on this rule, even going so far as to say that the original 4% rule was too simplistic because it was formed based on a worst-case scenario (which he considered to be the situation in 1968). Currently, the safe rate for drawing will be an average of 7% and 4.5% for an “all hell breaks loose” scenario.
He also demonstrated what the portfolio should ideally be for each year that he studied, as shown below.
Now, the question is how successful is the four percent rule? Well, that’s a mind boggling question to answer, because contrary to what Bill Bengen said, Financial Samurai (a popular blogger) claims that the rule isn’t relevant anymore because (i) the studies were taken at a time when bond yields were 5%, (ii) the studies were conducted historically, and (iii) markets can never be predicted (just imagine another 2008 crisis). Additionally, investment avenues are no longer limited to bonds and direct equities alone. They have expanded into other options following the dynamic changes in the financial services industry. There are also other uncontrollable factors: for example, something as simple as the year you were born can change everything you need to follow about this rule, depending on the rolling thirty-year returns, which for the S&P 500 index is as shown in the table till 2005 (after which we know what happened).
Even then there are calculations showing an in detail look into the success rate possibility for this rule as shown below:
In conclusion, even though the 4% rule acts as a guideline, it is up to you to look deeper into your own requirements because there are also other potential factors to consider: health expenses and risks, any other contingencies that could have personal impact, and constant economic changes that could potentially disrupt our portfolios or could directly affect the amounts required for expenses (current inflation highs, changes in taxes, etc.).
It is definitely tempting to follow this rule, establish one or several passive streams of income, and put your feet up. That said, I personally do not side with the idea of early and complete retirement from work. Why not work to your full capacity, to try and positively impact our world? Time is always the most important factor in life. Money flows in and out. Time travels ahead, never to return.
Do you think that this rule applies today, maybe with a few tweaks? Let us know in the comments.
Let us know what you feel in the comments.
Do refer to the following links as well:
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