How Does the 4 Percent Rule Work
The four percent (4%) rule is based on a withdrawal rate from your lump sum or savings. After studying historical data William Bengen determined that a safe withdrawal rate was 4% where you could safely withdraw this amount and not affect your lump sum.
This rule was then translated and adopted by large retirement funds and all the finance gurus as the gold standard to which we should all strive. It also made calculating your retirement really easy.
Work out how much money you think you need to retire on and live a happy day to day existence, divide that by 0.04 and you get the lump sum you need to retire.
Example $75,000 x 0.04 = $1,875,000.00, so I need to have a lump sum of $1,875,000.00 to retire on $75,000 a year and never touch the principle.
This is deemed as a safe withdrawal rate as you don’t know how long you’re going to live, so you can’t just live on the lump sum and withdraw whatever you want and expect it to last for possibly over 30 years, if you retire at 65 and live well into your 90’s.
There is a lot of debate surrounding the 4 percent rule and whether it is still applicable in the modern world. Some gurus now suggest the 3% rule as the gold standard. At first glance I didn’t understand this maths.
Example $75,000 x 0.03 = $2,500,000.00 so I need way more in my principle to make up my expected earnings of $75,000.
BUT, the argument is, save up as if you are going to retire at a 4 percent withdrawal rate and only live on 3%. This way your principle will actually increase instead of just providing your living allowance.
Example $50,000 at 3% withdrawal rate leaves $25,000 in the principle. So my principle now becomes $1,900,000 and I have lived a relatively OK financial life on $50,000 as well as increasing my nett worth.
BUT, if you have your portfolio in good dividend yielding stocks (stocks that pay you a percentage of their profit to shareholders) then these alone may suffice in terms of growing your portfolio. The bears in the marketplace (or chicken littles) also caution against market crashes etc. and advise against setting this type of investment and forgetting it.
So let’s say that there is a market crash and your invested $1.875M has now crashed out to $1M. You could adjust your withdrawal rate to 4% and now live on $40,000 a year instead. This is a significant drop in income but you know, life can be tricky and sometimes these things happen.
So now you’re eating ramen noodles instead of going out to a restaurant for your ramen noodles. You’re still eating though. That is my point. Throughout our lives this far we have had money come and go and adjusted our lifestyles accordingly (mostly) so if the worst happens, we’re pretty used to trimming back the fat.
What about just leaving it in the bank? As I write this in 2020 bank interest rates on savings accounts are pretty dismal at under 1%. The poverty line is pretty much determined to be under $18,500 but this can vary in each country and each government but let’s just say that’s where it is for this article OK?
So $18,500 is 1% of $1,850,000.00 with $25,000 left over to add to your principle. At this rate of return you might qualify for a government pension, but I’m betting they will be looking at the principle and saying no way. If you own your house, it may be possible to survive on this amount but honestly, with rising healthcare costs, it’s highly unlikely.
So it’s a risk and reward scenario. There are some other alternatives like term deposits etc that may yield you the 4% you need but these also come with a risk. Everything’s a risk. So decide your risk tolerance and make a decision already or get some financial advice from a planner you can trust and do not EVER give them access to your money to invest on your behalf.
Here is the link to the original article by William Bengen about the 4 percent, or safe, rate of withdrawal.
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