In the bi-weekly Stuff Our Parents Never Taught Us series I will introduce and clarify basic financial concepts in an attempt to increase the level of financial literacy among my Millennial peers. For some bizar reason, the majority of our parents didn’t think it necessary to teach us the 101 course of personal finance. If you’re over 18 and have no idea what stocks and bonds are, or how interest rates and dividends work, this is for you!
Now that you’ve lived frugally, saved rigorously and invested every penny you own it’s time to enjoy your financial freedom or even pull the early retirement trigger. But how big of an early retirement gun will you need? The most obvious answer is a massive tank with a large-calibre cannon. You’ll definitely hit the financial independence bull’s eye with that.
However, that’s not an option for most people since tanks are expensive – and probably illegal to own. As it turns out, though, even a small revolver might do the trick, depending on your marksmanship. And by marksmanship I mean your yearly expenses.
In 1998 three finance professors from Trinity University studied safe withdrawal rates of retirement portfolios. In their Trinity study paper they concluded that the maximum inflation-adjusted rate at which you can spend your savings without ever running out of money is 4%. Personal finance enthusiasts have turned to calling this the 4% rule.
What wizardry is this?! Or not, because you’ve already read the first two articles of this series on compounding interest and inflation, which are the two main ingredients of the 4% safe withdrawal rate.
The Trinity study
By studying a series of 15 to 30 years payout scenarios of a 50% stocks and 50% bonds portfolio between 1925 and 1995, the authors of the Trinity study found that people withdrawing up to 4% of their portfolio are extremely unlikely to outlive their savings. Even if you adjust the amount you withdraw for yearly inflation the chance of depleting your piggy bank is extremely small, especially for stock-dominated portfolios.
Logic dictates that when you safely withdraw 4% of your portfolio every year, you are able to retire when you have 25 times your annual spending. If you, for example, spend €20,000 every year, you’ll need a retiremend fund of €20,000 / 4% = €20,000 * 25 = €500,000. If you decide on a conservative strategy and only withdraw 3% every year, your portfolio should contain €20,000 / 3% = €20,000 * 33 = €660,000!
If you’re interested in simulating the 4% withdrawal rate for yourself have a look at FIRECalc. This great tool calculates the success rate of your portfolio over a certain period of time and provides an insightful graph that visualises almost one hundred possible outcomes.
Over time, many people have criticised the Trinity study and its outcome, most notably academic Wafe Pfau. While these critiques are in a sense justified, they don’t undermine the basic principle of the 4% rule. Even Pfau and his colleagues agree that for investors who can remain flexible the 4% spending rate still is a great strategy.
However, it should still be noted that the safe withdrawal rate study is based on the performance of US stocks and bonds only. The mileage of non-US investors may, as a result, vary. Unless you’re invested in very specific countries or regions, I don’t see an immediate reason to doubt the 4% rule though, especially considering the increasing number of multinationals in our globalising world.
Another limitation of the Trinity study is the short retirement time-span. Even though the authors have simulated 30 years of portfolio performance, many early retirees will have to make due with their nest egg for a much longer time. The study did, however, not take into account that retired folks might collect social security or a state pension. It’s also possible financially independent people decide to start a side hustle, which again reduces the need to withdraw 4% every year.
Doomsayers will inevitably point out that the study is, obviously, based on historical data which doesn’t hold any guarantees for the future. Even though geopolitical or economic events like hyperinflation can destroy a retirement portfolio’s value, the chances of that happening are rather slim. The timespan of the study (1925-1995) even contained the Second World War and saw some pretty inflationary periods like the 1970’s. Ultimately they didn’t matter too much to the success rate of the portfolios under examination. And even if there’s another world war, the entire economy will in all likelihood be down the gutter, so everyone will be in the same sinking boat.
There you have it, the 4% safe withdrawal rule. As long as the performance of your portfolio is higher than the sum of your withdrawals and the level of inflation you’ll never ever run out of money.
Even though the broad stock market always goes up in the long run, it’s bound to crash a couple of times in your life time. Because those few occasions are when the chance of depleting your retirement fund is the highest, it’s important to remain flexible in your spending. Maybe skip your yearly vacation abroad for a year or reduce your discretionary spending during an economic downturn if it makes you feel safer about not wiping out your savings.
Indeed, flexibility is key. While it would be terrible to deplete your retirement fund before being sent to the afterlife, ending up with a portfolio worth millions is also not the goal. Therefore it’s important to monitor the performance of your savings and adjust accordingly.
While I still haven’t settled on a definitive retirement plan, I’m sure it will be a combination of the 4% rule and dividend growth stocks. Because I expect to still own my exchange-traded funds in the future, I’ll probably sell off those shares to add to any future dividend income to cover my living expenses.
When will you have saved enough for retirement and what is your retirement strategy? Do you plan on following the 4% safe withdrawal rule?