The 4% rule is the golden tenet in the FIRE community. It is a calculation that tells you how much you need to retire, based on your annual expenses. Spend $50,000 per year? You would need $1.25 million ($50,000 x 25). You can read more about the 4% rule here and how it comes about.
As a financial adviser I generally dislike rule’s like this, and this one is no exception.
Other common personal finance rules are:
Your percentage allocation to stocks should be 120 minus your age; and
Your emergency fund should be 3 to 6 months of expenses.
After working with clients at all stages of life and at varying degrees of wealth, I have realized that no two clients are alike.
So how can you apply a general rule like the 4% rule to everyone? The problem I have is it is often quoted as the only number you need. People who use this rule, should provide a big disclaimer with it.
Sure, it can be a good starting point to let you know a ballpark figure of what you may need. But retirement planning is so much more nuanced than a simple rule. I just hate for people to use this calculation without realizing its limitations. It doesn’t consider you.
What are the problems with the 4% rule?
1/. The 4% rule doesn’t consider seasons of life
The 4% rule assumes your annual spending starts off at a certain level and increases each year with inflation in pretty much a straight line. But life does not work out like that.
For one, retirees often spend more in the early stages of retirement until maybe their 70’s, before reducing their expenses as energy levels reduce, only to see another potential increase later in life for healthcare and special accommodation needs.
Secondly, I don’t know about you, but every year I seem to have “one off” unexpected expenses. They happen so often that I can’t really call them one offs anymore. If you are planning on spending a certain amount in any given year, the chances of hitting that number are pretty low. Maybe you have an unexpected health cost, or need to provide for a family member, blowing your expected expenses out of the water.
These differences alone throw the 4% rule out the window, especially if they occur early in retirement. Increased spending early in retirement in combination with poor market returns, will expose you to sequence of returns risk where 4% may not work.
2/. The 4% rule doesn’t consider your own investment needs
The 4% study was based off an investment portfolio of greater than 50% stocks. If your own preference is to have more or less in stocks then the 4% rule goes out the window. If you invest more aggressively then the AVERAGE returns will be greater, but there will also be more failures where you run out of money. If you prefer to invest more conservatively, then 4% withdrawals won’t hold up.
3/. The 4% rule is not safe
A 4% withdrawal rate worked in 90% of scenarios according to the study. Thus 4% was deemed safe. I don’t consider that safe though. Yes, we are flexible beings and won’t let our money run out without making adjustments, but 90% is not safe. To sell it as such, as many people do, is wrong.
If the share markets go down early in your retirement, the odds of the 4% rule not working decrease significantly. 90% may then become 50% or less.
4/. The 4% rule does not include income
You may receive Superannuation income in retirement. Maybe some money from jobs. Perhaps a sale of a house. Maybe an inheritance. There are many ways you may end up with income in retirement. This will reduce your retirement needs substantially.
5/. The 4% rule is based on a time period of 30 years
The longer past 30 years your retirement goes, the lower the 90% success rate will become. Sequence of returns is one of the largest determinants of a successful retirement. The longer you are retired, the more opportunities you give sequence of returns to do some damage.
6/. The 4% rule doesn’t include fees
A lot of people use the 4% withdrawal rate thinking it is gospel. What many forget is that the study did not consider investment fees. Fees reduce returns. The 4% rule used actual stock and bond returns. All investments carry fees, so even a small 0.5% annual fee could potentially reduce the success of the 4% rule to well below 4%. A 1% fee reduces the 4% rule to 3.5%.
7/. The 4% rule was conducted under periods of high bond returns
The 4% study was conducted for 30 year rolling periods between 1926 and 1963 on the assumption of a portfolio of 50% stocks and 50% bonds. This period saw bond returns of over 6%. In recent times, bond funds have typically yielded only 2.5%. If this continues for much longer, there will be a lot a portfolios relying on this rule for retirement not turning out too well.
8/. The 4% rule assumes we are robots
If we see our portfolio being decimated, most of us will try and do something about. Maybe withdraw only 3% that year by reducing expenses. Or perhaps finding a way to earn a bit of income that year. The point is we won’t blindly sit by while our portfolio suffers. We will make the necessary adjustments in our spending and income. It may not always stop the entire slide, but it will increase our safe withdrawal rate.
Final thoughts
Don’t leave your retirement planning to something as crude as a rule of thumb. Your situation is unique and deserves more than a rule of thumb deciding your fate. Otherwise you may end up with not enough money, or possibly working far longer than needed. Retirement is the biggest financial move you will make and you need a well thought out, customized plan. Not a generalization.
If you need help with your personal retirement planning, then get in touch today.
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here