The Four Backstops to the Four Percent Rule

The four percent rule sure seems to get a lot of scrutiny. Is it too conservative? It is too generous? And of course, scrutiny from all sides is a good thing. We need to stress test the factors going into decisions we make with long-lasting implications.

The best theories and rules survive this scrutiny. But should we consider some external factors as well when applying a straight withdrawal rate rule to our retirement plans? The FI Tax Guy thinks so, and explains more about his thinking in this post.

The 4% Rule

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Boiled down, the rule of thumb states that an investor can retire when he or she (or a couple) has 25 times their annual expenses invested in financial assets (equities and bonds). They would then spend 4% of their wealth annually in retirement. The first year’s withdrawal forms a baseline and is increased annually for inflation.

The idea behind the 4% Rule is that the retiree would have a very strong chance of funding retirement expenses and thus would likely never run out of money in retirement. As a result, some refer to 4% as a safe withdrawal rate.

Maury is 50. He has $1M saved in financial assets. He can spend $40,000 in the first year of retirement. If inflation is 3% at the end of his first year of retirement, he increases his withdrawal by 3% ($1,200) to $41,200 for the second year of retirement.

Here’s how it could look:

Most investors aim for a greater than 4% return. In theory, with a 5% return every year, the 4% Rule would never fail a retiree. If you spend approximately 4% annually and earn approximately 5% annually, you have, in theory, created a perpetual money-making machine and guaranteed success in retirement.

The theory is great. But in practice, we know that investors are subject to ups and downs, gains and losses. What happens if there is a large dip in equity and/or bond prices during the first year or two of retirement? What if there are several down years in a row during retirement?

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