The essence of the so-called 4% Rule is that you can safely withdraw 4% of your invested funds each year, indefinitely. How did we arrive at that figure, and why is it the best figure to use?
The 4% Rule originally comes from a piece of research known as the Trinity Study, conducted in 1998 by three professors at Trinity University in Texas. They were trying to determine a Safe Withdrawal Rate for retirement portfolios, and looked at various mixes of stocks and bonds, over various time periods.
Back then there was a widespread assumption that you would enter retirement with a portfolio made up of 60% stocks and 40% bonds, due to bonds not being volatile in market crashes in the same way as stocks, and thus cushioning the fall in a portfolio. Since then they have fallen out of fashion somewhat, because we have realised the drag they cause on overall returns, and the problem that in some financial upsets they don’t in fact work as hoped - sometimes they fail to cushion the impact.
By studying past market behaviour, we know that a 4% withdrawal rate for a pure stocks portfolio is very safe, but it will be very prone to rises and falls with volatility. This leaves us exposed to something know by the complicated name of Sequence Of Returns Risk.
Sequence Risk, for short, means the risk that you encounter a market crash during the early years of your retirement. Your portfolio total will be lower, so that when you take out a given amount in pounds to cover your spending needs, you have withdrawn at a higher rate than 4%. You’ve made a bigger dent in your portfolio. If this downturn continues for months or years, there will be less in your portfolio to bounce back up once prices recover. You’d have a permanently reduced pot which may then not survive for the rest of your life.
There are a few ways of trying to deal with Sequence Risk. The traditional way was to include some bonds in your portfolio. The downside to this is that they produce less return, even in the good years, and so you’d need a bigger portfolio in the first place - you’d work for longer.
Or you could start your retirement with a cash buffer on top of your portfolio. If you had two years worth of cash to spend at the start, your portfolio would have two years to grow before you made any withdrawals. Normal years have healthy growth well in excess of 4%; your portfolio would be bigger and so when you began making withdrawals they would be lower as a percentage.
Or you could suck it and see. If your first years of retirement are all good years, or even average years, then you’re in much better shape. Your portfolio has grown ahead of your predictions and a downturn should only drag it back to where you began. The danger here is, what if your first years aren’t good years? The solution here is to be prepared to reduce some of your spending if there’s a crash. That would keep your effective withdrawal rate down and leave more in the pot to recover when the recovery comes.
This last one is how people really behave during market crashes, so as a strategy it has the advantage of being aligned with human psychology.
My approach is to adopt both the cash buffer and the drawdown-reduction methods. A third of my planned spending, during the early years of retirement, is earmarked for travel. In the event of a moderate downturn (say up to 10% reduction from the high point) I’ll reduce this spending by half. In a more serious downturn, a dip of more than 10%, I’ll halt this spending.
Using such a Sequence Risk mitigation strategy means I can retire on schedule; the alternative would be to work for longer, probably unnecessarily.
Coming back to the original question of how safe 4% is, there is a handy online tool called FIREcalc. It will let you backtest your retirement plan against historical date from the US stock markets. It uses data from the past 150 years or so, and looks at how your portfolio would have fared if you had retired in any given past year and its subsequent ups and downs. It will give you results both in the form of a very busy chart showing each of those retirement years, and a numerical figure - how many scenarios were successful. By that they mean, did the portfolio stay above zero until you died.
A 100% stocks portfolio over a 30 year period would have a success rate of 93.5%.
That’s before you take any measures like drawdown reduction during a downturn, or using a cash buffer. They should be enough to ensure success, right?
We don’t know. The future may behave differently to the past. We may encounter more extreme events than our forebears did.
This seems unlikely. Governments have, if anything, become more adept at understanding how the various levers they can apply will impact the economy. We make fewer dumb mistakes now.
The most extreme event of the past is probably the 1929 Wall Street Crash and subsequent Great Depression. A steep fall in stock prices, lasting for a long time. Most crashes are brief fluctuations by comparison. If you’ve played with FIREcalc to any degree, you’ll have noticed how hard it is to move your portfolio from 98% success up to a full 100% success - this is because of these very rare but very extreme events.
We have no guarantees that a portfolio will survive meeting such a deep crash, sustained for such a long time. And I’d argue that it’s probably not worth trying to. Surely it’s not worth working for an extra five years now, to build a fully bullet-proof portfolio, out of fear that you will be unlucky enough to hit a once-in-a-century crash in those early years of your retirement before your portfolio has grown an excess. I’d argue that it is better to mitigate that risk by reducing your spending if the worst happens, or by defending your portfolio from too much withdrawal in some other way, such as taking on some part-time work if a bad crisis hits.
There are plenty of people who argue that 4% is too cautious. They point out that in all probability a withdrawal rate of 5% or 6% will be just fine.
Just the same, we all worry about running out of money. Other people plan for a 3.5% withdrawal, to be extra safe. The risk to doing this, and more extreme withdrawal rates such as 2%, is that we sacrifice time. Time when we could be retired and enjoying life more than being at work. The FIRE movement is very focused on having your freedom whilst you are younger and in better health.
The withdrawal rate you choose to target is up to you. Most people agree that 4% is about right.