How much do you need to retire? Does the 4% rule for retirement even work anymore?
The 4% rule has as many skeptics and pessimists as it does optimists. Whichever side you sit on, one thing is for sure; we have reached a FIRE (financial independence, retire early (FIRE) paradigm shift. There are just so many questions and debates around this fundamental retirement calculation, that it’s probably time for a more nuanced view.
Especially after Vanguard presented an updated data model for the 4% rule, which may significantly alter many peoples investing and retirement strategies. You may now need more money to retire and you may be more pessimistic about your chances of early reitrement.
For others, it may be more of a question of how much freedom over their lifestyle they now have once they FIRE. It might even swing if they are even financially independent (FI) anymore!
I always considered the 4% rule for retirement to be a pretty robust rule. Regardless of the swings in the market, I thought as long as you did not exceed the 4% safe withdrawal rate (SWR) you would be fine. Thic comes with with the caveat that the market didn’t crash in the first couple of years of your retirement.
As it turns out, this might not be true anymore. So, in this article I want to discuss to what extent this is the case. As importantly, what can we do to ensure we stand the best chance of portfolio success in retirement.
Disclaimer: This article should not be considered as financial advice. You are responsible for your own financial research and decisions.
Andrew | Mr Money Side Up
What Is The 4% Rule (And Why Is It So Important)
The 4% rule is pretty much the foundation of the F.I.R.E movement – Financial Independence Retire Early. This is because retiring early is based on the premise that you can sustain a source of passive income pretty much indefinitely.
The 4% rule has long been touted as the rate at which you can withdraw from your portfolio over 30, 40 or 50 years and never run out of money. It’s a safe withdrawal rate.
As a result, the rule can also be used to calculate the portfolio value that many strive to obtain before claiming they are Financially Independent. Only when they reach this number will they retire early.
Those striving for early retirement often save aggressively and invest large proportions of their income. With the level of commitment and sacrifice that is required to achieve this milestone, portfolio success rate is absolutely crucial.
The 4% rule always needs rigorous scrutiny to ensure that one’s portfolio can be sustained after spending with inflation adjusted withdrawals and all the bear markets to come.
What’s The Problem With The 4% Rule
The 4% rule is treated almost as gospel in the FIRE community. I am 100% guilty of not spending enough time to interrogate the data that drives this model. Many of those that inspired my own financial independence journey use this rule.
Since Bergen’s original 1994 publication there has been little scrutiny over the rule. Aside from the authors updates in 2001 and 2006 with suggestions that it would be increased to 4.5% or that small cap stocks should be added.
This isn’t a criticism of Bergen, one man can’t do it all after all. However, I am definitely glad that Vanguard weighed in. Especially given how many new customers the FIRE community must have pushed Vanguard’s way.
What Are Vanguard Saying About The 4% Rule?
Essential Vanguard is outlining that there are some flawed assumptions behind the 4% rule and argue that:
The use of historical returns as a guide for future returns
A retirement horizon of 30 years
Returns equal to those of market indexes, without accounting for fees
A portfolio invested only in domestic assets (“home bias”)
A fixed percentage withdrawal in real terms (“dollar plus inflation”)
This leads them to conclude that the 4% rule was originally designed for investors with a 30-year retirement horizon. Therefore the assumptions are somewhat limited and this subsequently limits retirement planning. The 4% rule is also largely untested against modern day diversification and fees.
Whilst the 4% rule can be a good start for retirees it needs to be fine-tuned for the F.I.R.E. movement. The rule was conceived for a traditional retiree facing a retirement horizon of 30 years (Bengen, 1994), not for an early retiree who may spend over 50 years in retirement.
How To Improve Your Portfolio Survival Rate
Vanguard has come up with some updated assumptions and recommendations for improving your portfolio success rate. These small changes in the way we manage our portfolios can have significant and long lasting impacts. For example, changing to a dynamic withdrawal rate rather than a flat 4% can boost portfolio success by 34%!
Increasing your allocation of international investments, reducing fees and moving away from dollar adjusted withdrawals can all increase portfolio success rate. Whilst you can read these in more detail on the Vanguard website, I’m going to point out the aspect that I will probably incorporate into my own FIRE planning.
This is because some of the suggestions are around diversification and minimising fees etc., which I am sure we are (hopefully) already focused on.
Vanguard’s Dynamic Spending Rule Explained
Vanguard researchers have “created a dynamic spending rule that allows investors to spend more when markets perform well and that reduces spending amounts when markets perform poorly. Allowing for dynamic spending improves the chances that the portfolio will survive retirement”.
This dynamic spending rule describes a strategy whereby the investor would have a spending ceiling of 5% and a floor of -1.5%. Simply, when the market drops the dynamic spending rule dictates the retiree would cut back spending. This allows investors to improve the probability that their portfolio is not depleted and benefit more when the market rebounds.
Dollar Plus Inflation Rule Vs Dynamic Spending Rule
Whilst the 4% rule allows investors to withdraw the same, inflation-adjusted amount annually, even in poor market conditions; the dynamic spending rule maintains that an investor must reduce their spending. However, in good market scenarios the dynamic spending rule can allow investors to withdraw more money than the 4% rule does.
However, this dynamic spending rule still uses the 4% rule as a baseline withdrawal rate. For example, If the market returns 10% in the second year retirement then +5% can be added to the withdrawal rate. If you started retirement with a portfolio of £1,000,000 then you can spend an extra £2,000 on your baseline £40,000 (4%).
By contrast, if the market was to decline by 10% you would subtract 1.5% from your baseline. So you would only have £39,400 (-£600) to withdraw. Whilst this doesn’t seem a tremendous amount on the principle value, if the retiree is adjusting to 2% or 3% inflation in a down market then the disparity between the 4% rule and the dynamic rule would compound over time.
Will I Be Using The Absolute 4% Rule Or The Dynamic Spending Rule?
Does the Vanguard update influence my plan to retire by 2036? After all the calculations for this are based on the original 4% rule and I use them in my financial independence planner (Free Google Docs spreadsheet) and financial freedom excel calculator. Which you can use to calculate how much you need to invest each month to retire by a given date.
The 4% is supposed to be a worst case scenario concept. It indicates that whilst you can maintain a stable withdrawal rate in poor market conditions, you should not necessarily increase your rate in good market conditions. It makes sense right?
As you need the gains in good markets to weigh out the impact of steadily withdrawing during poor market conditions. However, the dynamic spending rule now seems to indicate that you can actually spend more in good times, but you have to suffer a little more through the bad.
Whilst this seems intuitive, it doesn’t seem as simple to follow as the 4% rule. For example, exactly what market growth or fall equates to what percentage deduction or addition to your safe withdrawal rate?
How Simple Is Dynamic Spending To Implement?
The ceiling of 5% up to a market growth of 10% works out at a rate of +0.5% for each 1% increase. By contrast a floor adjustment of -1.5% for a 10% drop would work out to 0.15% for each 1% decrease. Based on those rules, this is how the dynamic withdrawal rate works out across the spectrum. What do you think?
Whilst the dynamic spending rule allows flexibility and obviously promotes portfolio survival rate there is a problem. I would struggle to define how much I should uplift my withdrawal rate. However, it does seem straightforward enough to aim for this floor -1.5% adjustment.
When it boils down to it, even on a portfolio of £1,000,000, the dynamic spending rule is going to top off your withdrawal by as much as £2,000 in a good year and negatively impact you by -£600 in a bad one. For a 90.3% vs 56.3% i’d be more than happy to give up £600.
I think 4% is still pretty safe as long as you have that dynamic component. That could be dynamic spending but it could be fixed spending with some dynamic earning from part time employment. I have consulted to minimize my withdrawal rates until Social Security becomes available to us even though our withdrawal rate would have only been 2.7% without the consulting income. Mostly that was for fun though. After Social Security starts we’ll be under a 1% withdrawal rate without any earned income so I guess we were guilty of over saving. But my career was a lot of fun so I worked longer than needed. Good post!
I have not read the Vanguard paper yet but surely they are not suggesting getting rid of inflation adjustment entirely? That would mean never withdrawing 42k in your example – imagine what that buys you in 20 years time after a period of high inflation….
Hi Chris, thanks for leaving a comment. This is an interesting discussion point. Perhaps what Vanguard is suggesting is that you would have increased to 42k, then if the market increased by another 10% the following year, your safe withdrawal rate would increase to 44.1k (42k +5%). By contrast, if the market fell by 10% your safe withdrawal rate would become 41.37k (42k -1.5%) So the adjustments each year are in accordance to the market growth vs decline rather than inflation. What do you think?
Quite possibly true (I read the article now – its not clear at all!). Then the problem you have is if you are hit with sequence return risk in the first 5-10 years it will take a very long time to get the upside back. Imagine a bear market soon after you retire. 5 years of 1.5% reduction puts your absolute figure very low and then even if in the better years to follow its going to take a long time to get back to an inflation adjusted figure that you thought you would have when you started.
If they are saying ‘4% is too aggressive now given market conditions’ I don’t think this is offering a palatable solution for when the first few years are bad (which is what they are trying to protect against as its the highest risk scenario for running out of money)
I definitely agree with you that the Vanguard article isn’t clear. I would like to see them expand around many of your points!