August 3, 2020

The golden 4% rule

When I first found out about people retiring after a few years of work, I was obviously interested but I wasn’t all in right away. Could it all just be a bunch of bullshit? Maybe they inherited money or made millions at their job. Perhaps the best way to frame my state of mind; skeptical but optimistic. So naturally I did some research. One of the first things you come across when discussing retirement of any kind is how to make your money last. This is where the 4% rule comes into play.

If you aren’t familiar with the general concept of financial independence, you can get the general jist of it here. But essentially what it boils down to is having savings stored away and invested, and withdrawing that money at a reasonable rate over time. These rules apply whether you’re trying to retire at 25 or 65.

Because people heavily discount the importance of the future and just suck at saving money in general, having enough to last the rest of your life has been a problem for decades. We’re not the first ones to think about this issue. In fact, in 1998, an influential scholarly article was released discussing a study done about this exact problem. Commonly known today as the Trinity Study, it was the first one of its kind to complete a thorough mathematical analysis of retirement accounts and the longevity of people’s personal investments.

With the rise of the personal computer and the internet in the 90’s, being able to conduct rigorous simulations and calculations became much simpler. To give a cursory explanation, they looked at extended periods (i.e. 30 years) in the stock market and used a program to determine how much money would be left at the end of that time assuming they started with X amount of money and spent Y each year with real historical rates of return from investments factored in. (They used the S&P 500 for stock returns and high yield corporate bonds for bond returns.) They ran this for every combination of years possible (going back as far as data allowed). What they found was quite remarkable.

Regardless of how much money a person started out with, they could spend 4% of their total savings/investments each year and be quite certain they would never run out of money. To be more exact, they found that if you retired in any 30 year period from 1926 to 1995, and spent 4% of your investments annually, you would have money left after that time in 98% of the cases. Meaning, there were only a handful of years in which you could have retired where returns were so poor that you would have completely run dry before the end of the 30 year stretch. Let’s not forget, the great depression occurred during the late 20’s and early 30’s and was included in this analysis.

If you want to check out the study yourself (it’s about 8 pages long, pretty interesting concept but boring to read) you can here.

Before you tell me that 30 years and forever is not the same thing, let me tell you why it pretty much is.

In the majority of the cases they looked at, the total investment had actually increased at the end of the time period, and in some cases it increased substantially. For instance, if you retired in 1950 with $1 million and spent $40,000 per year in retirement, there was a decent chance you’d have something like $1.1 million or more in 1980. How does this work??? I’m glad you asked.

Like I mentioned before, if you don’t know about FI, check out the article above. If you do, then you understand that your investments make you money (but of course can also lower in value at times) while they are invested. The reason why 4% is so important is due to the historical average rate of return.(Again, another article I’d take a look at if you’re unsure what the ballpark is, but I’ll tell you right now it’s roughly 8-10% annually.) Which means of course if you’re spending 4% per year but making 8%, you’re coming out ahead 4% richer by the end of the year. However, if you factor in inflation (the rising cost of goods) which is typically around 2% and fees from your investments which could be near 1%, your “real rate of return” is about 1% that particular year. That being said, you still supported yourself financially for an entire year and came out richer at the end of it!

Of course, you should not think that you’re locked into spending 4% every year in retirement. In fact, I’d advise against that. If a particular opportunity arises requiring some extra cash above your original budget, don’t miss out because of the money. Do it, and perhaps spend a little less the next year if possible. The only way you’ll get yourself into trouble is if you make breaking your budget a habit. And yes, if the market boasts 50% returns one year, you’re allowed to have a little fun with your new found cash, just know that will not last indefinitely. On the bright side if you’re able to understand this concept and adjust your finances appropriately so that you come out ahead on a consistent basis, the difference between 30 years and 1000 is quite a bit more narrow than you’d expect.

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