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Quick Math - The 4% Rule

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Running out of money is a huge fear for retirees. Without proper planning, you could find yourself making an unexpected comeback to the office (hey guys, I'm back...).

The consequences of poor planning can be seen with millionaire athletes. According to a 2009 study, 78% of NFL players go bankrupt 2 years into retirement and 60% of NBA players are in the same boat after 5 years.

So how do people plan for retirement?

The 4% Rule

FIRE (Financial Independence, Retire Early) enthusiasts favour the 4% rule. The rule suggests you can spend 4% of your portfolio annually (adjusting for inflation each year) without running out of money.

For example, if you plan to spend $40K a year in retirement, you'll need $1M in savings ($40K/4%).

William Bengen first wrote about the 4% rule in 1994. He looked at rolling 30-year periods from 1926-1992 . He found that using a 4% withdrawal rate for a balanced portfolio (50% stocks and 50% bonds), retirees would survive even the worst 30 year periods.

Limitations of the 4% Rule

The 4% rule is not without flaws. For one thing, it's not a rule, but simply a rule of thumb. Take it with a huge grain of salt.

Your investment portfolio is likely different from Bengen's model. If your portfolio is more conservative (i.e more bonds), your expected returns are lower, meaning you'll have to spend less or save more. If you have a more aggressive portfolio (i.e. more stocks), you'll have higher expected returns but will contend with greater volatility. Higher volatility increases the risk you'll withdraw during a market downturn, adding additional complexities - such as adjusting your spending depending on how the market is doing.

The 4% rule was developed with a 30-year retirement in mind. For FIRE folks who aim to retire in their 30s, your retirement period is much longer (maybe 50+ years).  Bengen’s study showed a 0% chance of failure over 30 years BUT the chance of failure increases the longer the retirement. The failure rate is ~15% for 40-year periods, and ~ 30% for 50-year periods.

Despite the increasing popularity of the FIRE movement, most people are actually working longer. According to the Bureau of Labour Statistics, between 1977-2007, workers age 65+ increased 110%. The later you retire, the shorter your retirement. Blindly following the 4% rule could make you overly conservative. A much better problem to have than the opposite but something to consider nonetheless. You don't want to run out of money but you wouldn't want to sell your retirement short neither.

Bergen's study is also purely US-based and was done at a time where interest rates were much higher. Portfolios are increasingly global and the expected returns for bonds are much lower.

Wrap Up

The 4% rule is a quick and easy-to-use formula. It can give you a decent starting point for retirement planning. However, it's simply a ballpark figure (quick maths). To be best prepared for retirement, you'll want a plan that considers the uniqueness of your situation. A robust plan will ensure you have money to fund your golden years.

Poor planning is planning to be poor.


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