The 4% Rule – A detailed explanation of why its ALWAYS wrong

4% rule detailed explanation - Link holding 4% rule triforce
4% rule is legit and Link holds it above his head with pride.

If you are visiting this site you have probably wondered ‘how much money you need for an early retirement?’ but if you think about all the things involved, deciding on a number feels very hard!

You likely wish some would tell you how to find that number. Well, this detailed explanation of the 4% rule is exactly that!

The world is complicated so its hard to figure out. Inflation is a thing, stocks are always up and down, housing is nuts and who knows what the hell the economy is going to do.

For some reason someone on the news is saying ‘$1M certainly couldn’t be enough to retire on with Bolivian soybean prices being what they are!’ As is that is supposed to make sense!?! It all leaves you feeling lost and confused.

What about later on?

Even at that you are probably even just thinking about how things are right now. Really if you are planning an early retirement you really should know how these things will work out for the next 70 years right? Sounds impossible?

Well, knowing what is going to happen in the future is basically impossible but there is a solution. When you can’t predict the future you look to the past and that’s where big daddy Bengen comes in.

He’s the grand-daddy of retirement planning. He created the 4% rule, the best easy answer to ‘When can I retire?’. I will give a detailed explanation and go over it’s assumptions and its criticisms.

Before we plan our future though, we will start with a little history lesson.

History: the 4% Rule and an astronaut dropout

Long ago people used to plan retirement spending like a mortgage in reverse. You had a pile of money in the beginning which was invested and you took out a little at a time until it ran out.

It sounded smart but people in the industry knew the reverse mortgage method of retirement planning didn’t work very well. Mortgages were very nicely planned out whereas life in or out of retirement is not to simple.

If your investments were abnormally good or bad one year, or you took out an abnormal amount of money, the model ended up falling apart. It wasn’t considered a big deal though because once you stopped working back then no one really expected you to live for long anyways.

Big Papa Bengen. Creator of the 4% rule. Just look at that slick style. He knows what’s up.

Then grand-daddy William Bengen came along and he was a seriously smart dude.

He graduated from MIT with a degree in Aeronautics and Astronautics plus the lofty goal of being an astronaut. He even wrote a book about rocket design for MIT press in 1970.

However being an astronaut was hard so he abandoned that plan when it didn’t take off (zing!). His fall back career was just to become the COO and then eventually president of a pop bottle company. Later on, when that got old he sold the company and went and got his masters in Financial planning at 46 and changed the entire retirement planning industry.

The 4% Rule – Bengen changes the world

On retirement planning –
I searched through all my resources, including my CFP textbooks, and could find no good answers anywhere. Not surprising, as my generation was the first to expect such a long life in retirement; prior to that, it was live ten years after retirement, then die. I decided to do the research myself, which launched me on a totally unexpected journey.”
-Bill Bengen reddit AMA at 70 years old. Like a boss!

He saw the complexity of retirement planning and his big MIT astronaut brain realized that predicting the future was hopeless. So he looked to the past to try different retirement investment techniques to see what would have failed and what wouldn’t have over the years. He found something that worked through the stagflation of the 70s, the great depression and all the other crazy stuff that came along over the past century.

That creation was the 4% rule.

The 4% Rule Detailed Explanation

To make this wonderful 4 percent rule creation he grabbed US inflation plus stock and bond market averages for every year since 1926 as his data set.

Then he varied portfolio mixes, withdrawal rates and retirement start dates across the whole data set to see what would have made it to the end of his 30 year retirement case study. How did he use that data exactly?

Annual returns: He used the annual returns of the average stock and bond markets. It was easy to track throughout history and didn’t rely on you needing to be financially savvy to execute the plan.

Portfolio mix: The portfolio mix was set at some stock to bond ratio at the beginning of the retirement period. Then at the end of every year after that years returns were applied, the mix was rebalanced be once again be the original mix (which is generally a good thing to do anyways).

Withdrawal rates: The withdrawal rates he also varied by choosing a starting value at the beginning of the retirement period and adjusting it up with inflation as time went on.

The 4% Rule’s simple conclusion

Bengen discovered that in the worst case scenario you could still pull out 4% of your money every year from an investment while adjusting up for inflation. In that worst case scenario your money would last 30 years and all you had to do to make that happen was have 50%-75% stocks in your portfolio.

Your investment would grow fast enough to let you keep grabbing 4% of the money every year without it running out quickly.

 If you take out 4% of your money every year (inflation adjusted) your money will last forever, or at least 30 years in the worst situations. (Source: http://www.retailinvestor.org/pdf/Bengen1.pdf)

Blamo – the 4% rule. Just save up until 4% of your investment covers your planned retirement spending. Such an easy answer for ‘How much money do I need for retirement?’

When you combine this with the easiest money saving system ever you will actually be taking easy street to financial independence. Then when you combine it with trying to spend a little less in retirement you’ll be retiring any day now.

The Trinity Study – 4% Rule’s Holy Blessing

After the study’s release other financial planners thought it was too simple and must be missing something so they tried to break the 4% rule but always failed. Still, it didn’t really catch on until three professors from Trinity University wrote a paper on it in 1998.

This was called the Trinity Study named for the three authors from Trinity University. In it they decreed that the 4% rule was in fact, legit.

Behold, I am the 4% rule and I am legit

They found that yes, if you had 50-75% stocks and the rest in bonds, then it was almost guaranteed that you are fine through economic hard times.

Then when it was officially blessed as being safe it exploded everywhere. Financial advisors love the idea of using something safe and simple. No one wants to recommend something that might lead to a client coming back to complain about them either from being too aggressive or being too difficult to follow. It was perfect for retirement planning!

Why is the 25x rule nicer than the 4% rule?

Some people prefer to think about the 4% rule in reverse, its easier on their brains. In reverse, you could just think about how much money you need to enact the 4% rule. 

Once you save up 25x more money than you plan to spend every year, you will spend one twenty-fifth of it every year…which is 4% of your savings (4% = 1/25). So some people call the 4% rule the 25x rule. It makes it very obvious why its better to spend less money every year.

Really it is nicer. Multiplying something by 25 feels a lot easier in your head than dividing by 4% but Bengen made the 4% rule so I’m not changing the name for your brain’s comfort level.

The 4% Rule’s secret destroyer. Solved?

Now you have saved up the you need to live of of but there is still one horrible fear lurking around.

Inflation. Booo hissss

Inflation is the reason why your grandparents thought there were splurging when they bought bread for a nickel or a house for $1000. Things just cost more over time which makes your savings worth less than when they started. There are economic reasons why it happens but they don’t really matter.

The important thing is if you don’t plan for it your retirement will end up getting obliterated by the price of gasoline in year 2070.

Sounds annoying? It is but the beauty of the 4% rule is that inflation is already taken into account in the 4% withdrawal rate. Bengen just worked in inflation into the equation by jacking up the withdrawals by the rate of inflation. 4% is the starting withdrawal rate, then it floats up as inflation happens.

Is inflation taken into account properly for your future? Probably, the planning method worked for the last 100 years and will probably work now too.

How do YOU deal with inflation?

Its simple. Every year the government will tell you what inflation was in your country for the previous year. All you do is increase how much you withdraw from your savings by that much.

You were pulling $50,000 this year and inflation was 2% last year. Now you can take out $51 000 next year. If you don’t feel you need it, don’t use it, but its there for you and shouldn’t hurt you to take it. Pretty easy stuff.

4% rule is too good to be true right?

Well yeah, there are complaints about the 4% rule. Its basically always wrong in some way.

All the complaints and issues originate from what it was trying to solve. The future is uncertain. People have issues signing up to something that covers the uncertain times of the future.

Some people think 4% is too high and some people think its too low. We’ll talk about the arguments. 

4 percent rule is too high! You’ll fail later

The general argument against the 4% rule is that even though it has been vetted to work over a the past 100 years, this time, it’s different.

“The past 100 years were too good.”

“The data was based on the USA and the USA is special.”

“Investments are different now.”

The counter argument is pretty easy though. Is it really that much worse? The 4% rule would have led you to an indefinite retirement even if you retired right before the great recession in the 1920s. That is the gold standard of bad stuff! Maybe this time its different but…really it’s probably not.

The 4% is already conservative. Based on the historical study there are only a few situations where you couldn’t have lived forever on 4%. Even pulling money out at 5% would have left you indefinitely fine in most situations.

Even pulling out 5% of your money every year (inflation adjusted) usually lets your money last forever. 50 years was when he stopped calculating, not some magic value.

4% rule is too conservative. You’ll die rich!

This is another downside of not knowing the future. There is a small chance that pulling 4% of your money every year won’t lead you to indefinite retirement but there is a MUCH bigger chance that 4% is much too little to grab every year.

In Bengen’s paper he found that in most cases, if you take 4% a year for 20 years you will end up with way more money than you started with! I don’t know if that would make you feel smart or stupid but in most scenarios pulling 4% and starting with $500,000 leaves you with over $1,000,000 and often over $2,000,000 twenty years later.

Grabbing 4% per year usually leaves you with 100% more money than you started with…or more!

Having extra money later on probably doesn’t sound too bad but when you’re 80 would you have rather spent that money on your new luxury gold plated dentures or spending time with your kids in your 30s. While being a baller in your retirement home sounds amazing, having the time and money when you are young and fun sounds better to me.

Why are we arguing about 4% vs 5%? It’s almost the same.

Sometimes when you hear about some studies the results sound like trivial updates only interesting to nerds the world over. Its a 1% difference who cares. I do god damnit and you should too!

4% vs 5% might sound insignificant but if you walk through the calculation it matters. Even if you just think about the number backwards, it sounds more important. The 4% rule is the 25x rule, and the 5% rule would be the 20x rule (5%=1/20). Saving up to 20x your retirement spending is definitely way easier than getting 25x the money.

Let’s say you decide you need $60,000 a year to live happily. Then you need savings of either $1.5M or $1.2M ($60,000 x 25 vs $60,000 x 20). That’s a difference of $300,000. Doesn’t sound so small anymore does it?

If you save $60,000 a year that’s around 5 years of extra time grinding away before you are free. In that time no one taught Billy how to climb trees properly and now he has a funny looking nose from a big fall. Three points of contact people. Honestly, it should be taught in kindergarten.  

So now you get it, it matters. What do we do?

Beating the 4% rule – Can you outsmart an equation?

My main issue with the original studies is that they assume that everyone is a dumb spending robot.

I get it. The simulations are much simpler if everything is perfectly repetitive but it’s pretty easy to outsmart a money spending equation.

I don’t even have to make up weird examples. Big daddy Bengen worked it out over 20 years ago. If your investments tank for some reason all you have to do is cut back your spending a little to be fine. Cutting back your spending to 3.8% instead of 4% of your savings and adjusting for inflation from there leads you to have 20% more money in the bank after 20 years than if you didn’t make that little cut.

That shows even a small adjustment can have a big benefit to your retirements longevity. If push comes to shove you can stay retired if something bad happens.

Travel to Thailand. It helps your retirement?

The adjustment doesn’t have to be anything crazy. Maybe change your vacation plans from Finland to Thailand one year and boom you’re fine (Finland is pricy). Suddenly you have excess money saved up when you previously had too little.

Or you can be smarter than our spending equation. If there is a huge market crash (you’ll see at least one in your life), you can push your money into 100% stocks. It’s not crazy to do once the prices are nice and low although it is scary.

If you did that, you would end up with $42M in the bank EVEN if you were pulling 4% a year and retired right before the Great Recession in the 20s. That was one of the worst times in economic history to have just retired so beating this robot sounds pretty easy to me.

Enter the 4%-ish rule

So what does all this mean for us? Well we should start off aiming to save up enough money to live off a 4% withdrawl rate. During our journey there we may decide that we are comfortable with less savings for a bunch of reasons.

Maybe you decide its better to be stingy one year if something horrible happens than keeping working for years just in case. Or we are motivated enough to learn to beat the market average somehow which makes the 4% rule too safe for us.

Simple as that. Its comfort level and experience that will tell you how much to stray from the super safe 4% value, maybe all the way up to 5% if you are feisty. We have plenty of time to figure that out though.

Should you plan to overshoot the 4% rule?

On the other hand, is there a situation where you should you plan to save up to live off less than a 4% withdrawl rate? Totally.

If you are scared of not having a 100% guarantee of not needing to adjust your lifesytle or you hate the concept of ever adjusting your lifestyle, then over saving is good.

Toss some extra money to get yourself down to a 3.5% withdrawl rate so that you can sleep like a baby at night. It is 100% worth it if you feel you need that piece of mind.

What did I do?

  • I started out with the 4% goal because I didn’t know any better.
  • Over time I realized I could easily achieve my retirement income with less than the 4% rule predicted. That just meant I was closer to FIRE than I thought.
  • I saved my way past my needed retirement income because I wanted to live it up in my retirement and wasn’t in huge hurry to jump ship.
  • Wrote a blog about it 😛

TLDR / How to activate the 20x-ish rule?

  1. When you are starting out your FIRE journey saving up to a 4% withdrawal rate is a good target to set.
  2. Choose a stock/bond mix (I recommend 70%/30% to start) and start investing accordingly.
  3. At the end of every year check if your investments are still the same as your original mix. Adjust to make sure it is that mix by buying or selling things.
  4. Try to reduce your life’s expenses to reduce the amount you need to save.
  5. When you are on your path to FIRE decide if you want to live with the possibility of temporary belt tightening or the need to be smart when times are tough. If you aren’t cool with those things, stick to 4% a year or a little less (3.5%).
  6. If you hate every minute of your life while you work, make a speedy exit as soon as you hit that 4% or 5% point. Belt tightening probably sounds better than being in that hellscape you call work.
  7. Breathe deep. You made it.
  8. Enjoy life doing whatever it is you do. Playing with your kids or crushing grade schoolers at recess with your sick pokemon deck. Whatever, just enjoy it.

That is our detailed explanation of the 4% rule. Now you have a target so you have no more excuses to hold back. See you on the FIRE escape!



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2 thoughts on “The 4% Rule – A detailed explanation of why its ALWAYS wrong”

  1. When you are going to finance your retirement by withdrawing money each year from a pension plan you need to know how to get the largest possible income without risking that your fund will expire before you do. The Bengen Rule doesn’t help you do that, and actually produces a much smaller income than you could have, leaving more money for your descendants than you may want.
    Bengen looked at the actual experience of the previous fifty years to determine the maximum amount that you could have withdrawn every year in all his 21 sets of (overlapping) thirty years’ investment returns. Unfortunately, there are no theories in economics or mathematics to suggest that all future thirty-year retirements will be no worse than the particular past experience that he reviewed. The world has changed considerably since the particular markets in his data, and what happened in the distant past does not foretell the future.
    The income produced under the Bengen Rule depends on what the fund value happened to be when it was applied, which creates inconsistencies. The rule says that you should take an annual income of 4 per cent of that initial market value. If market values go up, say, 20 per cent the rule says that you should continue withdrawing 4 per cent of that initial value (subject to an adjustment for inflation). If, however, someone new has a fund with the same increased value as your fund, they will apply the rule and conclude that they can safely withdraw an amount that is 20 per cent more than you can. They cannot both be right.
    The biggest problem with Bengen’s methodology is that, even if you could identify the withdrawal amount that had only, say, a 1 per cent probability of your being cleaned out, there would then be a 99 per chance that your retirement income would be less than it could have been. The Bengen Rule systematically and significantly under-distributes retirement income, and builds up reserves that are rarely used.
    Bengen assumed that everyone wanted an income that was level in real (inflation-adjusted) terms. There are two components of a retirement income: amount and duration. The uncertainty created by the volatile market values of investments is inevitably going to be manifest in one or the other. The Bengen Rule fixes the amount withdrawn, which means that you then have no control of duration: you cannot know how long your retirement fund will last. All Bengen could say was that if the future were no worse than the past it would probably last at least 30 years.
    When you start living off your pension pot, a level income may seem desirable. If after a few years, however, investment performance has been better than expected, you will wonder why you cannot increase your withdrawals, instead of leaving all the excess return to build up a larger estate than you intended. Conversely, if investment performance has been disappointing, you will want to cut back the amount that you withdraw to prevent the stream of income drying up.
    It is sensible to dispense with a level income based on the possible worst-case scenario, and take instead an income based on what is most likely to happen, and adjusting that in the light of actual investment returns. It would work like this. Each year you take first the cash proceeds from dividends and interest. You then notionally spread the fund’s current market value over several years and withdraw one year’s proportion of that. In this way you will increase your income when the investment return has been better than expected, and reduce your income if it has been worse than expected.
    The number of years that you spread the fund’s capital value could be something like “half way to age 95”, but with a minimum of, say, five years to stop it going below one year, which would use up all your capital.
    Your income will fluctuate, but it will be much less volatile than the underlying fund value because the dividend component will be more stable, and the capital component will be smoothed by the spreading system. Importantly, the investment uncertainty will be reflected entirely in the amount that you withdraw, and so the duration will be whatever you chose it to be.
    There will be an added bonus: compared with the Bergen Rule you will sell a bigger proportion of your fund when stock prices are high, and a smaller proportion when they are low. This feature is the reverse of dollar-cost averaging, which adds value when you buy stock by regularly investing a level amount of cash.

    Reply
    • What a comment! Wow!
      I totally agree the 4% rule is always wrong in some way and errs on the side of being conservative. That’s why it’s popular though.

      Adjusting as the future plays out in some way is definitely the solution. I’ve seen a couple of theories like yours and they all seem like they ought to work.

      I have a lot of my money in real estate so realistically the 4% rule is totally out the window for me. 😛

      Reply

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