Anyone who has read about being financially secure or the FIRE movement, Financial Independence Retire Early, has heard to save for retirement. To make sure you have enough money saved and invested for you to support your lifestyle without working. But how much is enough? The answer to that question is the 4% rule, or as we’ll later learn in the post the 3 to 3.5% rule.
The 4% rule is a withdrawal strategy used during retirement. If you only withdraw a certain percentage amount per year, adjusted for inflation, you will have enough money to last you the rest of your life. You will adjust the percentage withdrawal rate to the expected portfolio returns and your life expectancy.
William P. Bengen first introduced the idea in 1994 in his article Determining Withdrawal Rates Using Historical Data. Bengen first started with an asset allocation of 50% stocks and 50% bonds. Using a conservative 3% withdrawal rate, he tested how long a portfolio lasted over different starting points in history. Starting in 1926, before the great depression, the portfolio would last 50 years in every case. The periods include the great depression periods of 1929-1931 and 1937-1941, as well as the recession of 1973-1974. Thus, if a retiree wants to be truly certain his or her money will last the rest of their lives, a 3% withdrawal rate would almost guarantee their nest egg to last. But, what if 3% of your retirement savings is not enough to meet your spending needs? How much higher of a withdrawal rate could you take?
3% is a Safe Bet
Increasing Bengen’s conservative 3% withdrawal rate to 3.5% will be safe as well. In all cases, a retiree’s money will last 50 years at 3.5%. At 4%, a retiree will begin to have periods where their money will run out, with the shortest period being 33 years and it will last 50 years most of the time. Depending on the age of retirement 33 years may be enough given life expectancy.
Ideal Asset Allocation Mix?
The next question is what is the correct asset allocation mix? Bengen performed various test ranging from 0% stocks and 100% bonds to 100% stocks. The results where surprising. It was riskier holding too little stocks. How can holding more stocks than bonds be risky? In this case you need to think of risk as the possibility of having money run out, not the yearly volatility of stocks. While that may seem counter intuitive keep in mind that stocks over a long time period offer a greater return than bonds. If your return over a 10-year period is higher than your withdrawal rate, then the money in your portfolio will last. He found that a 50% to 75% stock allocation is ideal. I would advocate going even higher to 90% based on Warren Buffet’s 90/10 Stock and Bond split.
Keep in mind that deviating from your withdrawal rate can be detrimental, especially in the early years. Since your money will compound over time, a higher withdrawal in the first year can adversely affect your savings. (Sigh, that hot tub will have to wait.) That additional money withdrawn will not be able to earn a return. After all, the goal is to have your money work for you.
Before you use Bengen’s advice, make sure that you have the discipline to stick to it. If you really need motivation, imagine what Chuck Norris would do. He would kick temptation down before it even had a chance. After all, when Chuck Norris falls in water, Chuck Norris doesn’t get wet. Water gets Chuck Norris.
A lot of times people look at the negative side of what they feel they can’t do. I always look on the positive side of what I can do. “– Chuck Norris
Adjusting for Market Conditions
Given the valuation of equities today, 4% may be too much of a withdrawal rate given expected returns. If you want to be sure you will have a steady income stream for the rest of your life, I would suggest 3% to 3.5%. I expect returns to be in the 3.5% to 4.% range over the next decade. If 3% to 3.5% is not enough to support your current life style than you should consider reducing cost to a smaller home and/or cheaper area of living. Also, working for a few more years may be advisable to further build your nest egg while giving your portfolio the chance to compound for a few more years without withdrawals.