Adjusting the 4% rule

The “4% withdrawal rate” is a rule of thumb used by many financial advisors to guide on how much to withdraw for your living expenses every year. It goes something like this:

  • In the first year, withdraw 4% of your net worth.
  • From the second year onwards increase this number by the inflation rate.

This rule came from a frequently quoted paper (“The Trinity study”) done in the 1990’s by Bill Bengen. Since then people have been using it like a mantra. However, it is important to note that that study was based on a particular set of circumstances.

Limitations of the 4% rule

Only considered 30 year time periods

Traditional retirement at age 65+ meant you only had to plan for a period of 30 years or so. People however, are living longer than ever. Also if you retire early, you have a longer period that you need to take care of, for your living expenses.

Only considered a portfolio of 50% stocks and 50% bonds.

As I mention in the other article, for longer retirement periods, you need to have a higher percentage of stocks.

Withdrawal rate was considered rigid

The trinity study assumed that the 4% rule was rigidly followed in both market up years and down years. So in a year the market was low, the retiree withdrew the same amount of money (in effect selling more stocks at a lower price), thus impacting the portfolio’s ability to recover.

Had an aim of nearly 100% chance of success

Failure is defined as the retirement fund going down to zero in any of the 30 year simulations. Even if one 30 year period between 1925 to 1995 resulted in a failure, but all the other periods were successful, the rate was still considered to have a failure.

How to tweak the 4% rule

As a FIRE retiree, you might need to plan for 30, 40, 50 year timeframes. There are ways on how to tweak your plan slightly to deal with longer time periods. You can use one or more of the following methods

Aim for a higher target net worth

Instead of the 25X rule (i.e. save 25 times your annual retirement expenses), you could aim to save 30X. This reduces the chance of failure dramatically as it gives your fund enough cushion to recover from bad years.

Choose a lower withdrawal rate

Instead of withdrawing 4% in the first year, you could use 3.5%. This method also reduces the chance of depleting your funds

Be more flexible in your withdrawals

Instead of rigidly following the 4% rule, you can choose to be flexible with your withdrawal rates during market recessions. This means that in years where the stock market is down considerably, you adjust your withdrawal amount to be lower. Then ramp up your withdrawal rate after the market recovers

Invest primarily in stocks

Again, if you have a very long retirement horizon, you should have a bigger portion of your net worth in stocks. See this article for more details.

If you follow one or more of the above methods in combination, you can significantly reduce the uncertainties that might keep you up at night!