Here’s a quick calculation that can show you whether your finances are ready for you to retire: Take your last 12 months of spending and multiply it by 25. If your investment portfolio exceeds the product, you’ve crossed the threshold of financial freedom. If not, keep socking away until you get there.
This quick math is an offshoot of the 4% rule, a centerpiece of conversations between people on the cusp of retirement and their financial planners. If a potential retiree has assets of $1 million, they can retire safely if their annual spending is less than $40,000 a year (i.e $1 million x 4% = $40,000).
Two decades ago, that’s all a 65-year-old needed to think about before cashing in on their hard-earned social security and pensions. But today, retirement itself has become more fickle, the result of fraying social safety nets, the changing employee-employer contract, and spillover effects from the global financial crisis; according to Gallup the average projected retirement age is 66, up from 60 in the 1990s.
What’s more, the glory of retirement is no longer the exclusive domain of the twilight years. Now, some people in their 30s and 40s aspire to spend most of their lives not working, and need their finances to be up to the task. This is the appeal of the Financial Independence, Retire Early (FIRE) movement, whose disciples range from college kids to Google engineers, unified in their aim to save at least 50% of their income to reclaim their retirement destiny.
So should you base your anticipated retirement on the 4% rule? Does it matter whether you’re planning to retire when you’re 35 or 65? What are the assumptions that go into the rule and where could you get tripped up?
It’s all about withdrawal rates
A typical retirement account is comprised of financial assets such as stocks, bonds, mutual funds, and bank deposits. These financial assets are held primarily in 401(k)s and brokerage accounts. Over the course of a person’s career, the theory holds, both pools of assets should grow—first from additional contributions (such as automatic deductions into your 401(k)retirement account), and second from the increase in their value (i.e. stock prices going up).
If all goes according to plan, once you leave the workforce, you can live off the interest and dividends these assets produce, or you can sell them off little by little as a substitute for the income you once earned.
And here’s where the 4% rule kicks in. Let’s walk through the math:
- Take your retirement portfolio (let’s use $1 million)
- Multiply it by 4% ($1 million * 0.04 = $40,000)
- If the result ($40,000) is greater than your annual spending, all systems go!
You can also flip the calculation around by taking something that you know—your annual spending—and seeing how much money you’d need today (i.e. your hypothetical portfolio) to be able to retire. Here’s the calculation in reverse:
- The 4% rule states that you can retire if: Portfolio size * 0.04 > Annual spending
- Re-arranging the formula yields: Portfolio size > Annual spending / 0.04
- And since dividing a number by 0.04 is the same thing as multiplying it by 25 (since 1 / 0.04 = 25),
- It follows that you can multiply your annual spending by 25 to determine if you have enough to retire
The 4% rule is officially known as the safe withdrawal rate (SWR). First defined in the 1994 article “Determining withdrawal rates using historical data,” financial planner Bill Bengen used historical data to show that a retiree would be safe (i.e. they would not outlive their savings, according to actuarial estimates of life expectancies) if they spent no more than 4.2% of their portfolio each year.
Three professors—Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz—from Trinity University corroborated Bengen’s findings. In 1998, the trio published a study that used slightly different portfolios (different percentages of stocks and bonds, or other assumptions about a person’s longevity) to arrive at a similar conclusion: a 4% withdrawal rate gives you a 95% chance of being safe.
Twenty years later, the Trinity Study, the 4% rule, and safe withdrawal rates are used interchangeably among people in retirement and those looking to retire. Mr. Money Mustache (née Peter Adeney), the FIRE movement’s de facto chief evangelist, argues in a blog post: “Far from being a risky proposition, assuming 4% safe withdrawal rate is actually the most conservative method of retirement saving I could possibly recommend.”
Putting a price on health
The studies behind the 4% rule assume that your retirement will last for up to 30 years. If you retire in your early 60s and live to about 80, that feels like a safe bet. But it can be hard to predict how long you’ll live; though the average life expectancy is 76 for men and 81 for women in the US, we all know (or have at least heard of) exceptions who have lived well into into their 90s. For those privileged enough to live extra long lives, the rule would fail, possibly putting their financial stability at risk.
Now imagine looking to FIRE in your 30s. Simply because of their age, younger folks have a higher likelihood of reaping the benefits of medical breakthroughs that could extend life expectancies. How could you project your future expenses if you become the first person to live to age 150?
Another critique of the 4% rule is that life is messy, complicated, and unpredictable. No matter your age, it’s simply unrealistic to assume that one’s spending stays constant over time. Add to that the variability of healthcare costs—one researcher found that someone earning an average wage in 1958 had to work “nearly 15 days” to cover a particular medical expense, while a worker in 2012 would need 58 days’ worth of wages—and it seems absurd to assume that one number could so much of your future financial livelihood. Furthermore, the size and long-term viability of entitlement programs such as Medicare and social security are not a guarantee. Even for people retiring now, relying too heavily on these programs to take care of you in retirement is no longer the safe bet it once was.
Rising medical bills are part of why retirement can be so expensive. In the 2013 paper “Estimating the true cost of retirement,” David Blanchett, the head of retirement research at the financial research firm Morningstar, observed that “there appears to be a ‘retirement spending smile’ whereby the expenditures actually decrease in real terms for retirees throughout retirement and then increase toward the end” driven by a “significant increase” in relative healthcare spending exposures.
But if you’re looking to retire in your 30s and kids are a part of your future, the dramatic uptick in costs for things like education and healthcare might not leave you smiling at all. In 2017, the US Department of Agriculture estimated the cost of raising a child at $233,610—excluding the cost of education (private college cost an average of $35,676 per year in 2019). Conversely, pursuing a “DINK” (dual income, no kids) lifestyle would make your spending more predictable.
The future is fickle
If you have that gnawing feeling that the viability of the 4% rule is left over from an era in which we could count on systems not to fail, you wouldn’t be alone. Professional investors, academics, and policy-makers have been debating if the combination of the 2008 financial crisis, along with global central banks’ aggressive monetary policy (focused on keeping interest rates historically low to stimulate economic growth) has permanently changed the future return prospects of both stocks and bonds.
One of the anchors of any retirement portfolio is the US Treasury bond, which pays interest and principal (i.e. the amount you invested in the Treasury bond) with the backing of the US government. The bonds have the highest credit rating of any investment in the world, which means the chances of not getting your payments are extremely low. That means they’re a great source of income for retirees.
When Bengen introduced the 4% rule 25 years ago, a three-month US government bond paid interest at a rate of 4% which means you could pretty much guarantee the 4% needed for the rule to hold, with low risk of losing your invested money (as it would require the US government go bankrupt). Therefore, your spending could be easily covered by a very low risk investment. Today, that same bond pays a paltry 0.04%, forcing retirees to invest in far riskier instruments to clear the 4% threshold.
Those risky investments usually take the form of stocks, which zig, zag, and occasionally crash. Therefore, the timing of your retirement also impacts the validity of the 4% rule. If you started your retirement the day before the global financial crisis, you’d be hit with a double whammy: You’d have to sell investments that have lost money, with no chance for them to recover their value. Investors refer to this as sequencing risk—the sequence of your returns affects your outcomes.
In their 2013 paper “The 4 Percent Rule is Not Safe in a Low-Yield World,” Blanchett, alongside retirement researchers Michael Finke and Wade Pfau, argue that “the success of the 4% rule in the US may be a historical anomaly” and it “cannot be treated as a safe initial withdrawal rate in today’s low interest rate environment.” Today, this may be even more true.
What’s in a number?
Regardless of your age, planning your retirement around a single number is a risky proposition. The 4% rule is a great starting point, but assessing the likelihood of not outliving your retirement funds requires many more assumptions and calculations, then evaluating these assumptions under extreme circumstances (i.e. you live 10 years longer than the average life expectancy).
Plus, as you look further into the future, predictions begin losing their accuracy. It’s quite easy for Tim Cook to predict how many iPhones he’ll sell tomorrow. But how about in ten years? Cook could probably still make an educated guess by extrapolating from current trends, but we’d all acknowledge that many unknowns could dictate the final outcome. Humans, what with their surprise expenses, are even less predictable.
For FIREees, the 4% rule is a decent starting point, but it shouldn’t be where their retirement preparation ends. So what makes Peter Adeney (aka Mr. Money Mustache), who retired at age 30 with a family to support, come down so confident in the the 4% rule? In his post “It’s all about the safety margin,” Adney argues that FIRE itself has given him the flexibility and resilience to survive any potential negative financial and spending surprises arising from retiring early.
Adney believes that retiring at a young age afforded him the option to change his spending habits, such as moving to a smaller house or take fewer trips, or even re-enter the workforce to earn some additional income. There could also be positive surprises, as Adney doesn’t factor social security into his 4% calculation. Should it still exist in 30 years, it would be all gravy for his family.
To anybody evaluating their retirement, the 4% rule is a decent starting point, but fails to paint the entire picture. But whether you’re four or forty years from retirement, it’s a quick calculation that can determine if you’re on the right path.