Financial Literacy
Living By The 4% Rule
When can I retire? How much money do I need to save up? You’re definitely not the only person to have asked themselves these questions. If you have spent any time researching retirement, you probably have heard of the 4% rule. If you haven’t heard of it, you’re in luck. Here in this article, we talk about retirement and living by the 4% rule.
What Is The 4 % Rule?
The 4% rule suggests that if you spend 4% of your assets in your initial year of retirement, and then adjust for inflation each year going forward, you will be unlikely to run out of money. To put some numbers to it, if you wanted to retire and spend $40,000 per year, adjusted for inflation, from your portfolio, you would need to retire with one million dollars to adhere to the four percent rule. This rule is alternatively described as the requirement to have 25 years worth of spending in your portfolio to afford retirement. 1/25 equals 4% – it’s the same rule. While it is simple and elegant, the 4% rule does has some limitations and this retirement plan strategy may not be applicable to all, especially if you plan on retiring early.
Where did The 4% Rule Come from?
The 4% rule comes from William Bengen, a financial planner who submitted his study in the Journal of Financial Planning. According to Bengen’s model, the investment portfolio consisting of 50% stocks from the S&P 500 index and 50% intermediate-term US government bonds. Bengen’s analysis used a rolling 30-year period analysis which ranged from 1926 to 1992. For example, the model would look at the period 1926 – 1955, followed by 1927 – 1956, and all the way to 1963 – 1992. Bengen found that even the worst 30-year period the investment portfolio was able to support a withdrawal rate of 4%. From this simple but innovative analysis, the 4% rule was born.
How Much Do I need to Personally Retire then?
Since you’re reading this article, you’re most likely wondering what’s the magic number for you. And the answer is – it depends. Everyone’s number is different as it depends on many factors, such as, your area’s cost of living and your quality of life at retirement that you desire. The best way to find out what is your 4% rule number is to track your expenses. No matter how large or small, we recommend you to document everything and consider to add a reasonable amount safety for unexpected surprises. Once you figure out your projected annual expenses, multiply that by 25 to determine how you personally need to save for retirement.
What's The Catch?
While the 4% rule is a reasonable place to start, it doesn’t fit every investor’s situation. Here are some of the limitation:
- It’s a fixed rule. The 4% rule assumes you increase your spending every year by the rate of inflation (3%) which can be a challenge for some retirees. It assumes you never have years where you want to spend more, or less than the allotted amount. This requires great discipline and isn’t how most people spend in their retirement. Expenses may change from one year to the next and the amount you spend may change throughout retirement. This is one of the reasons why we suggest a safety figure to account for unexpected surprises.
- It applies to a 50% stock and 50% bonds portfolio composition. The rule applies to a hypothetical portfolio invested 50% in stocks and 50% in bonds. Your actual portfolio composition may differ, and you may change your investments over time during your retirement.
- It assumes a 30-year time frame. In Bengen’s study, the 4% rule with a 50% stock 50% bond portfolio was shown to have a 0% chance of failure over 30-year historical periods. However, the chance of failure increases to around 15% over 40-year periods, and closer to 30% over 50-year periods. Depending on your age, 30 years may not be needed or likely. According to Statistics Canada, the average remaining life expectancy at the age of 55 is just shy of 30 years. We believe that retirees should plan for a long retirement. The risk of running out of money is an important risk to manage.
What Should I do Next?
The 4% rule is a good starting point and a basic guideline on how much you need to save for retirement for a 30-year retirement of your choice. But after that, we suggest you to personalize your retirement portfolio, based on your projected spending rate, life situation and risk tolerance. Remember to regularly update the portfolio as life can always throw you a curveball.
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