If you’d eventually like to stop working and live life on your own terms, you need to know how much to save.
The 4% rule
The conventional wisdom is that you need to save up enough money so that you can live on 4% of your total savings per year. For example, if you can live on $40,000 per year, then you would need to save up $1 million. If you spend $80,000 per year, then you need to save $2 million.
In other words, the 4% rule states that you can safely withdraw 4% of your retirement portfolio each year and not run out of money during a typical retirement.
The Trinity Study
The basis for the 4% rule comes from a famous study called the Trinity Study, which came out of Trinity University in 1998 and was updated in 2010.
In this study, the authors divided up all of our prior financial data from 1929 to 2009 into 15-year, 20-year, 25-year, and 30-year rolling periods. The authors back tested each period to determine what would happen to a portfolio during that time period at different withdrawal rates.
Trinity Study results
The results of the updated Trinity study are illustrated in the table below. The percentages in orange refer to the withdrawal rate, or the percent of the portfolio spent in the first year. This is assumed to increase with inflation each year.
The table is further divided up into different portfolio compositions, ranging from 100% stocks to 100% bonds. The percentages in the body of the table refer to the likelihood that your portfolio will have a value greater than zero at the end of that period (i.e. you didn’t run out of money).
Let’s focus on the payout periods for 30 years, a typical length of retirement. The results of the Trinity Study show that as long as you have at least 50% stocks in your portfolio and withdraw no more than 4% of your portfolio each year (adjusted for inflation), there is at least a 96% chance that your portfolio will survive 30 years. Hence the 4% rule.
Notice that if you try to withdraw greater than 4% of your portfolio (like 5% or 6%), success rates go down considerably. Also notice that if you don’t have at least 50% stocks in your portfolio, success rates also go down because the growth of your portfolio will not outpace inflation.
Problems with relying on the Trinity Study
The Trinity Study is a landmark study and everyone should at least be marginally familiar with it. However, there are two main problems with the assumptions in the Trinity Study:
- Past performance is no guarantee of future performance: The Trinity Study used back tested data. There is no guarantee that future stock market returns will be as good as past returns. If future returns are lackluster, then the 4% rule may not be safe.
- Your retirement may be longer than 30 years: The Trinity Study did not look at retirement periods longer than 30 years. If you live a long time or retire early, you could be looking at a retirement of 40, 50, or even 60 years. In such a scenario, the 4% rule may not be safe.
Addressing the above concerns
Early Retirement Now has an excellent series on safe withdrawal rates, addressing the above issues. We’ll consider each issue in turn.
Addressing lower future expected returns
Like most goods and services, stocks can be considered to be overpriced or underpriced. The relative price of the stock market (e.g. S&P 500) can be expressed with a metric called the cyclically adjusted price to earnings (CAPE) ratio. The higher the CAPE the more overpriced the stock market.
The chart below shows the CAPE ratio over the last 100 years.
The median CAPE is around 16, and the current CAPE is 30. It turns out that the CAPE ratio is correlated with future stock market returns. Higher CAPE ratios are associated with lower expected future returns, and lower CAPE ratios are associated with higher expected future returns. Our current CAPE of 30 is considered high and in general we would expect much lower returns going forward.
Early Retirement Now analyzed safe withdrawal rates at different stock market valuations. Here are the takeaway graphs.
This first graph (above) shows the probability of success with a 4% withdrawal rate at different CAPE ratios. At a CAPE > 30 (as it is currently), the 4% rule only has a success rate around 40%, even in a portfolio with a high percentage of stocks.
This second graph shows the probability of success with a 3.25% withdrawal rate at various CAPE ratios. Here you can see that if you lower your withdrawal rate to near 3%, even with a CAPE>30, the success rate is greater than 95% with at least 50% stocks in your portfolio.
Addressing retirement periods longer than 30 years
Early Retirement Now also analyzed safe withdrawal rates for retirement periods lasting longer than 30 years. His results are shown in the table below.
As you can see, if you’re planning on a retirement lasting 50 or 60 years, the 4% rule starts to fail and the 3% rule looks more appealing.
A balanced approach to the safe withdrawal rate
Although I have pointed out why a 4% withdrawal rate may be overly aggressive in many scenarios, the best approach to this whole discussion is to hedge against uncertainty and remain flexible.
If you expect a 60-year retirement and you retire when stocks are overpriced, then plan on a 3% withdrawal rate. If you expect a 20 year retirement, have additional sources of income (such as social security or a pension), and retire when stocks are cheap, then it may certainly be reasonable to plan on a 4% (or even higher) withdrawal rate.
More than anything else, it is important to remain flexible in retirement. If stock market returns are particularly dismal during the early years of your retirement, it might be reasonable to cut spending or pick up a part-time job. If stock market returns are exceptional then it may be reasonable to spend a bit more and splurge on a nice vacation.
Safe withdrawal rate “rule of thumb”
In conclusion, there is no safe withdrawal “rule”. Rather, there are safe withdrawal “rules of thumb.” Remain flexible and understand that the 4% rule may not work in all situations.
Here’s to 33 years of expenses! To be simple and safe, determine your “Number” by 33x annual expenses.
I loved ERN’s “Ultimate Guide to the Safe Withdrawal Rate”. The amount of rigorous analysis there is truly amazing. But when all is said and done, to avoid excessive complexity, just target a 3% withdrawal rate, which as you point out, means 33 years of expenses.