The Four Percent Rule: What’s All the Fuss About?

The four percent rule is a well-documented basis for retirement portfolio withdrawals. It's even become a cornerstone of financial independence planning for many. But how useful and relevant is it in reality? And what risks does it bring?
Four percent rule

A lot has been made of the 4% rule for many years now. Some have extolled its virtues as though it’s a completely foolproof retirement approach, while some have warned it’s no longer fit for purpose in our new-age, low-interest developed economies.

The truth, as is often the case, is somewhere in between. But before we go through how the principle stacks up, let’s start with a recap of what it’s all about.

What is the four percent rule?

The 4% rule argues that you should withdraw 4% of your investment portfolio each year in retirement. The idea is that, on average, you’ll achieve a return of 6% to 7%, and therefore have room to combat against inflation and a 4% annual withdrawal. In other words, 4% should provide sustainable retirement income, maintaining an overall balance that keeps that income flowing through retirement.

From the perspective of someone pursuing early retirement, the principles can be crudely inverted to give an idea of the sort of sum you’d need in this portfolio. We can do this by calculating 25 years of our desired income.

If I wanted, for example, to retire with an income of $50,000, that suggests I’d need a portfolio of $1,250,000. But be careful. That sum is in today’s value. You need to adjust your assumptions based on inflation over your years to retirement.

How robust is the four percent rule?

The 4% rule was first articulated by William Bengen in 1994. His analysis looked at historical data on stock and bond returns over a 50-year period from 1926 to 1976. At its core, Bengen wanted to assess how different withdrawal rates coped during downturns like the 1930s and 1970s. He concluded that no historical case existed in this dataset where 4% withdrawals exhausted a portfolio in less than 33 years.

And so the 4% rule was born.

But it was only popularised following the Trinity study, which used the same dataset and similar forms of analyses. While neither study firmly concludes that 4% is a completely safe withdrawal rate, the Trinity study does state that “for stock-dominated portfolios, withdrawal rates of 3 percent and 4 percent represent exceedingly conservative behaviour.”

This has generally been reaffirmed by updated studies. The authors of the Trinity Study provided updated research in 2011, stating in their conclusions:

 “Clients who plan to make annual inflation adjustments to withdrawals should plan lower initial withdrawal rates in the 4 percent to 5 percent range, again from portfolios of 50 percent or more large-company common stocks, in order to accommodate future increases in withdrawals.”

The updated view is pretty consistent with the original research. Holding a portfolio of 60% stock and 40% bonds should allow for a 4% withdrawal rate for at least 30 years without exhausting the retirement portfolio. In fact, some critics argue that a 4% withdrawal rate is overly cautious and will leave retirees with leftover balances.

So it’s pretty bulletproof, right?

Well, no, not exactly. Historical data isn’t necessarily an indication of future performance.

We now live in a very different economic climate, facing substantially lower returns on cash savings and short-term deposits. To make the 4% rule viable in today’s economy, this likely means we need to shift the balance of our retirement portfolio even more towards higher-returning asset classes like equities.

That might mean, for example, that the originally analysed split of 60% equities and 40% bonds would need to shift to 70% or 80% equities. And this, of course, comes with elevated downside risk. The more our portfolios shift towards equities, the more timing (and luck) play a bigger role in both the period of accumulation and drawdown.

Early retirement and the four percent rule: some caveats

And what if we want to retire early? Does the 4% rule help us here? There are a few takeaways worth flagging on this matter.

#1: Is a long-run annual return of 7% realistic?

Achieving the returns required is more challenging than before with a 60/40 split of stocks and bonds. And if we want to retire early, the 4% rule needs to carry our portfolios even further through the decades. Accounting for inflation and fees, that likely means achieving a consistent annual return of 7% over the long term.

Now, we know historically that returns on equities and property can deliver here, but risk appetite, timing and diversification play an important role. Anyone gearing up for a very early retirement based on the 4% rule needs to strongly consider, particularly in the light of the modern macroeconomic climate, if such a return is likely to be sustainable over the long term. History supports it, but that’s no guarantee of future returns.

#2: Inconsistent drawdowns and emergency costs

Deviating from the 4% principle, to make a large purchase or to cover an unforeseen emergency cost, can also have serious knock-on effects on subsequent years. The 4% rule requires a degree of consistency. This means living a lifestyle within your annual withdrawal means and having space for emergencies in your 4% income.

If you want to operate with a little more flexibility in retirement, you’ll probably either need a bigger starting portfolio or a different drawdown approach.

#3: The importance of diversification

The recommended formula for the 4% rule is 60/40 stocks and bonds. As we already know, that mix may not be the most appropriate in current economic conditions. But it’s crucial, too, that our mix within each asset class is well diversified. This optimises our risk-adjusted return over the long term.

For a non-expert, risk-return profiles are more stable if we invest in index funds over the long term, for example. This gives a good level of exposure to a balance of equities from different industries and counters idiosyncratic risk. It’s Investing 101 but it’s worth mentioning as it’s a key assumption in the 4% rule analysis.

#4: Timing (and luck) matter

If you invest over a period of, say, 20 years, you’re likely to see a stable return of 7% (pre-inflation). If you’re lucky enough to start your investment journey at the pit of a recession and retire at the top of a boom, your accumulation journey will look very different. Of course, the reverse is true of a recession.

Similarly, when you reach your 25-year target is also relevant. If you start to drawdown at the top of a bull market you’ll experience heavy losses, compounded by the drawdown. Your portfolio will then have less value to compound when the economy begins to turnaround.

This is part and parcel of world of investment, but it’s particularly noteworthy if you’re looking to get to your magic 25-year number in quick fashion. If you looking to reach your 25-year figure in 10 years or less, for example, you’ll be much more exposed to the risks presented by ordinary and extraordinary economic cycles.

#5: Exhausting your portfolio

The 4% rule is predicated on the idea of enduring for at least 30 years. In fact, almost all analyses over history suggest it would be very unlikely you’d die having exhausted your retirement balance. If legacy wealth in your retirement portfolio is not all that important for you, and assuming you achieve a 7% long-run return, the 4% rule might not be for you.

The upshot for financial independence

The 4% rule is not a silver bullet for early retirement, but it does provide a good structure for target setting and a relatively sustainable drawdown approach – assuming historical long-term returns on a diversified portfolio prevail in the future.

That said, it’s just a guideline. When we talk about financial independence, it’s perhaps more useful in the context of helping us determine our independence figure.

But achieving the passive income required to be financially independent does not necessarily have to rely on a portfolio of stocks and bonds. There are a whole host of ways to achieve sustainable sources of passive income, not restricted to financial markets.

My view is that financial independence is achievable way before we have 25 years of income in equities and bonds. There are other approaches that can compliment the accumulation of wealth in a standard retirement portfolio.

Freeing up liquidity from property by downsizing or relocating. Developing a source of passive income that requires human capital instead of monetary capital. Supplementing our threshold financially independent income with jobs we enjoy.

The 4% rule is a useful framework, but it’s not the only road to financial independence – as some may lead you to believe. It carries its own assumptions and risks, it steers us in the direction of two asset classes, and it focuses firmly on monetary instead of human capital. That’s worth considering before putting all our eggs in its basket.

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