Is the 4 Percent Rule for Early Retirement Officially Dead?

I’ve heard rumblings around the personal finance and FIRE community that the “4 percent rule,” a popular early retirement withdrawal strategy, might be outdated for a while now.  But has the day finally come?  Is the 4 percent rule officially dead!?  

With Inflation at levels we haven’t seen since the 1990’s, and future market returns expected to be lower for the next decade, many experts are finally calling it. 

Is there any hope left for the 4 Percent Rule? 

Morningstar recently released a safe withdrawal study suggesting that the 4 percent rule of thumb should be revised to 3.3 percent.  Others in the personal finance community are more pessimistic. However, while early retirement just got a bit riskier, it seems that the 4 percent rule might still be relevant for some early retirees.  But it’s no longer a slam dunk.

Morningstar’s “The State of Retirement Income” report is 59 pages long.  If you’ve got a ways to go on your FIRE journey, you may be satisfied just reading the cliff notes.  Morningstar plans to update this report every year.  However, if you’re nerdy (like me), or planning to retire within the next few years, it might be worth your time and/or sanity to give the entire document a read.

In addition to sharing my key takeaways from the study in this post, I’ll also share how this impacts our early retirement plans.

What is the 4 percent rule?

To summarize, the 4 percent rule is a retirement withdrawal strategy popularized by the Trinity study back in the 1990’s.  The study evaluated the success rate of different withdrawal rates and portfolio allocations over rolling 30-year periods since 1926.  Researchers found that a withdrawal rate of 4%, increased for inflation each year, was highly successful in most scenarios for a balanced portfolio.  This withdrawal rate was then deemed “safe” and has been used by retirees and early retirees ever since. 

If you’re not familiar with the 4 percent rule, check out my original post, with more details on the Trinity study.  

If the 4 percent rule is outdated, what’s the new safe withdrawal rate for early retirement?

As I’ve written before, most people use overly optimistic growth rates when projecting out their investment balances. 

One of the reasons for this is recency bias, whereby we are biased towards results which have occurred most recently.  Recent stock returns have been substantially higher than historical averages during the past 30-40 years. As such, recently bias causes us to assume these returns will continue at such high rates.

That assumption may not be accurate. Many experts, including those at Vanguard, are predicting that we’ll have a period of lower returns for both stocks and equities over the next 10 years.

As mentioned above, Morningstar recently came out with their estimate of a safe withdrawal rate for the future of 3.3%.  They identified the following distinguishing features of the current economic environment, as compared to historical values, as a reasons we need to reassess the 4 percent rule: (1) lower bond yields; (2) stock valuations at all time highs; and (3) low inflation.  The first two features suggest lower withdrawal rates, while the third would support higher rates.

Similar to the Trinity study, Morningstar considered these factors, and applied them to several different portfolio allocations and timeframes to determine what a safe withdrawal rate might be for future retirees.

Morningstar’s assumptions

To arrive at a safe withdrawal rate of 3.3%, Morningstar made or used the following assumptions in their analysis.  Some of these we’ll discuss further below.

– The real withdrawal amount is fixed, increased only for inflation each year.  That is, there are no changes to withdrawals made in reaction to market performance or changes in spending.  This is similar to the Trinity study.

– Income outside the core retirement investment portfolio was ignored, including social security benefits, pensions, or other income.

– The study ignored dividends and assumed all withdrawals made by selling assets

– Success was determined as a 90% or greater chance of the portfolio lasting 30 years  

– The expected annual rate of inflation used was 2.21%.

– 10% of the investment portfolio was assumed to be held in cash.

– The selected 3.3% rate is based on a portfolio of 50% stocks and 50% bonds.

– The portfolio allocation weightings and projected (arithmetic) returns used were as follows:

Results of the study  

Using the above assumptions, Morningstar projected a range of safe withdrawal rates for different lengths of time (10 – 40 years) and equity weightings (0% – 100% equities). 

The range of safe withdrawal rates for a 30-year retirement was 2.7% (all bonds) to 3.3% for portfolios holding between 50% and 60% equities.  These same rates for a 40-year retirement dropped to 2% and 2.8%, respectively.  In other words, much less than the 4% rate many of us have been using.

Morningstar acknowledges that some of the assumptions they use are conservative, stating that:

“by relaxing these assumptions or adopting a more flexible spending approach, our analysis finds retirees can safely sustain higher withdrawals, with a 4.5% starting real withdrawal rate achievable under some scenarios”

While it may seem counterintuitive that the best results occurred in the balanced portfolios, you have to remember that this study relied upon fixed withdrawal amounts.  Which means that even though equities average returns higher than bonds, bonds have historically been less volatile. Continuing to withdraw significant amounts during or following down markets can severely hinder the longevity of a retirement portfolio, especially in the first 10 years or so.  This higher risk in earlier years is know as the “Sequence of Returns” risk.

How to maximize your withdrawal rate: Is a 4 percent rate still possible?

The short answer is yes. 

While riskier than it may have been in the past, the 4 percent rule might still work for some, even in early retirement. Though, the rate you ultimately choose should depend on your personal circumstances and risk tolerance.

There were a few limitations in the study, in addition to some strategies you can use, which can improve your safe withdrawal rate.

Be flexible

Morningstar’s report states that its analysis ignored the possibility that a retiree might be willing and able to modify spending from year to year, based on actual market results.  Because of this, they extended their analysis to consider the impact the following four flexible withdrawal rate strategies would have on the results:

– Forgoing inflation adjustments in years following down markets

– Using Required Minimum Distributions (RMDs)

– Reducing spending by 10% following down market years

– The Guardrails method, a more complex strategy that involves taking less in down markets and more in up markets.

The analysis reviewed these strategies using the same 50/50 portfolio, finding that all four increased the safe withdrawal rate.

The Guardrails produced the highest safe withdrawal rate at 4.86%.  However, even just forgoing inflation following down market years increased the safe rate from 3.3% to 3.76%.  In addition to being simple, forgoing the inflation adjustment, would rarely result in a noticeable deterioration in quality of life.

If you’ve created a reasonable post-retirement budget that includes a robust amount of discretionary spending for things, like travel, you might also rest easier.  As the difference between your fixed and discretionary costs grows, so does your ability to flex spending when needed, as compared to someone operating off a very lean budget. 

Consider (or earn) additional income

The study also excluded non-investment income, such as social security benefits, pensions, or any other income earned during the retirement years. 

While pensions have become a rarity, most American workers will receive some amount of social security income.

Additionally, many early retirees will accidentally or intentionally earn income during their retirement. This income could cover some living expenses and decrease the investments need to be sold in a given year.  

If you’re planning to pursue a hobby which can be monetized or treated as a business for tax purposes, consider doing so.  You don’t have to earn a lot or rely on that income, but it could help… or at least offset the hobby’s costs.

The extra cushion from these income resources might just be enough to provide the comfort you need to use a higher rate of withdrawal.

Be (a little) more aggressive

The Morningstar study contains logical reasons for why the balanced portfolios performed better than the stock-heavy ones.  However, if you’re willing to reduce withdrawals following down years, you’ll have flexibility to choose a more aggressive portfolio.  

Additionally, the presumed cash allocation of the portfolio was 10%, which in many cases may be a bit too conservative.  Since cash has a much lower expected future return, decreasing this position in favor of bonds or stocks should improve projected earnings.  That said, you want to carry at least enough cash to cover one year of expenses (more if you also have a low bond allocation).

Other ways to improve your portfolio’s chances of outlasting you? 

Well, the study suggests delaying retirement, but that may not be what you want to hear.  The shorter the retirement timeline, the higher withdrawal rate you can use.  

Engaging in tax planning and keeping investment fees low can also go along way towards stretching your portfolio. 

Something else that you can (and should do) is to take steps today that could help minimize future costs.  The biggest expected cost in retirement is healthcare.  Doing what you can to improve your health today could save you big in retirement.

What withdrawal rate will we use?

As mentioned in our 5-year early retirement plan, we don’t plan on pulling the retirement trigger immediately after reaching financial independence. 

So, while it’s easy for me to calculate our FIRE number using the 4 percent rule, we’ll ultimately have the option to use a lower withdrawal rate if we choose to (unless we also incrementally increase our budget).

The honest truth?  Relying on the 4 percent rule for early retirement scares me. 

It’s not that I don’t trust the math.  I believe that many key tenants of the Trinity study still hold true, especially when utilizing some of the strategies mentioned above.  And as for the longer timeline, if you’re withdrawing less than your portfolio earns each year, you should (in theory) never run out of money. Of course, theory isn’t reality.

Our reality

When we finally reach financial independence next year, I will have just turned 40 and Mr. RFL will be 35.  That’s pretty young for retirement… compared to almost any standards.  

Hopefully we are able to enjoy a really long retirement.  But a long retirement also means more time for things to go wrong, including those that we can’t even imagine yet.  So, it would be naïve to say that we’ve got it all figure out.  We don’t. 

Because of that, and the fact that we have a young child to consider, I don’t want to take any unnecessary risks.  I never want the reason we don’t or can’t do something that we want or need to do to be money.

That said, we are entitled to receive pension benefits of approximately $10,000 per year starting at age 62 (less if taken earlier), as well as social security benefits. While this income will offset future costs, I haven’t included them in our FIRE calculations. We are also very willing to flex our spending in order to preserve our portfolio in down markets, and have a healthy budget for discretionary spending which could be reduced when needed. Finally, we are both very employable and young enough that we could earn additional income if necessary. 

For all these reasons, I haven’t ruled out the 4 percent rule just yet. I’m planning a post on our investment withdrawal strategy for early next year and will consider this information as I compile that post.  Stay tuned…

Do you think the 4 percent rule is too outdated for early retirement?

What withdrawal rate do you think is safe?

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