The "4% Rule" and Early Retirement

Updated on February 5, 2018

The 4% Rule is a guideline to help retirees determine how much they can safely withdraw from their nest egg each year. Before examining how the "4% Rule" applies to early retirement, let's look at the more traditional concept of retirement. This is the model that the 4% Rule was originally designed for.

What Is Retirement?

The financial life of most adults can be broadly broken into two stages: accumulation and decumulation. In this model, one plans to save (accumulate) money until roughly age 67, and then start spending (decumulating) one's savings. This retirement model is supported by the government in several ways:

  • Tax Sheltered Savings: The ERISA Act created special tax-advantaged retirement accounts such as the 401(k) and IRA. In these accounts, one's retirement savings can grow tax-free. But you can only contribute to them if you are making taxable ordinary income (a wage). Additionally, you might have to pay a penalty if you take money out of them before age 59.5.
  • Social Security: All employees are required pay a portion of their salary into this program. At retirement age, people start receiving inflation-adjusted lifetime pension benefits. Mike Piper has an excellent post explaining how Social Security benefits are calculated. The earliest that you can start receiving Social Security benefits is age 62. However, the earlier that you start receiving benefits, the less you will receive. You must contribute to the program for 10 years before you can receive benefits.
  • Medicare: All Americans who have worked at least 10 years and are age 65 are eligible for health insurance through Medicare. Until then, most Americans get health care through an employer. Many people find getting insurance coverage outside of employment to be difficult and expensive.

Both Social Security and Medicare are guaranteed by the government to last for the rest of your life. If you have made it this far, then congratulations - from a financial perspective you "have it made".

Retirement Spend Down and "The 4% Rule"

Many people, though, find their Social Security benefit to not be enough. Additionally, the future of Social Security is uncertain. Therefore, many people save a portion of their salary each year with the intent of spending it during retirement. Most people try to put this money into tax-advantaged accounts and invest it in a mixture of stocks and bonds. The book A Random Walk Down Wall Street has excellent advice on this process.

The two most basic questions about this process are:

  1. How much money do I need to save?
  2. When I retire, how much of my nest egg can I safely spend each year?

The "4% Rule" tries to give individuals a clear rule of thumb about retirement spend down. It says that if you are planning for a 30-year retirement then you can plan to spend 4% of your nest egg, and adjust it for inflation, for each year of your retirement. For example, if you have saved $1,000,000, then you can expect to be able to spend, adjusted for inflation, $40,000 per year during a 30-year retirement.

Details about "The 4% Rule"

The 4% Rule comes from what is known as The Trinity Study. It was a paper written in 1998 by three finance professors from Trinity University. You can read the full paper here. The paper is actually titled "Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable". In 2010 Wade Pfau updated the research of the Trinity Study with data through 2009. You can read his paper here.

If you read the actual study you can see that these results come with a lot of caveats. For example:

  1. Results differ based on the balance of stock and bonds held
  2. Some sample portfolios "failed" (ran out of money)
  3. The "experiments" were only conducted over 30 years (you might live longer)
  4. The study ignores taxes and costs (e.g. expense ratios of mutual funds)
  5. There is no contractual obligation involved (unlike a pension or annuity).

Additionally, experts are constantly debating the applicability of this rule, as well as the many other approaches to retirement income. The "4% Rule" is best seen as a useful guideline to help you decide how much money you need to save in order to enjoy a particular standard of living during their retirement. It is not a guarantee.

Wikipedia has an excellent article on this topic titled retirement spend down. One thing which is immediately clear is that the 4 Percent Rule is just one of many approaches to managing a retirement portfolio for income. Additionally, the biggest risk that retirees face is longevity risk (the risk of outliving one's money). Ironically, most individuals do not think about longevity risk when contemplating retirement.

What Is Early Retirement?

Early retirement is the attempt to, well, retire early. More specifically, proponents of early retirement aim for financial independence as a central goal of life. By not requiring a paycheck from an employer you can spend your life as you see fit. Retirement, in this sense, is not necessarily about living a life of leisure. There are many worthwhile endeavors that are not financially rewarding. For example: raising children, creating art, helping the poor and pursuing a spiritual practice. The idea is that once one is free from needing an income, one can dedicate one's life to these activities without regard to the money that they may or may not generate.

The first book I read that touched on this was The 7 Stages of Money Maturity by George Kinder. A book that is more referenced in the Early Retirement community is Your Money or Your Life by Vicki Robin and Joe Dominguez. More recently, Jacob Lund Fisker wrote the influential book Early Retirement Extreme. A key point that Fisker makes is that in order to retire early, you must save a large percentage of your paycheck.

Does the 4% Rule Apply to Early Retirement?

The 4% Rule was never intended to apply to horizons longer than 30 years; therefore, it does not apply to early retirement. It might be possible that a lower withdrawal rate can safely be applied to time horizons longer than 30 years, but to my knowledge no one has conducted that research yet.

Another disadvantage to early retirement is that you forfeit many valuable government benefits. For example, you can only contribute to a tax-advantaged savings account if you are receiving a wage. You can only receive Social Security benefits if you are at least age 62 and have worked for at least 10 years; and the longer you have worked, the larger your benefit. Similarly, you are only eligible for Medicare if have worked at least 10 years and are age 65.

If you know more about financing early retirement, please leave a comment!

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    • AMFredenburg profile image

      Aldene Fredenburg 

      5 years ago from Southwestern New Hampshire

      Food for thought! so many people thought they had their retirement secured, and then, whammo! I'm sure this info helps.

    • tipstoretireearly profile image

      tipstoretireearly 

      6 years ago from New York

      The 4% rule is a good starting point. For early retirees, its more important to monitor your progress from year to year, and be willing to make adjustments to your lifestyle should it become necessary even if it means spending less than 4% for a limited time period.

    • Ari Lamstein profile imageAUTHOR

      Ari Lamstein 

      6 years ago from San Francisco, CA

      @Nords,

      Thank you so much for your thoughtful and informative comment!

    • profile image

      Nords 

      6 years ago

      Ari, there's been quite a bit of interest in the 4% SWR since the Trinity Study, and it turns out that much of the work can be extended to retirements longer than 30 years.

      For example, Raddr has done extensive modeling of the 4% SWR here:

      http://raddr-pages.com/research/

      Much of the portfolio's success depends on the sequence of the market returns experienced in the first 10 years of the retirement.

      Although there's insufficient historical data to support modeling of longer retirements, as Paul says, Monte Carlo simulations work fairly well. They have their own drawbacks as mentioned here:

      http://the-military-guide.com/2011/10/27/problems-...

      and many more calculators are discussed here:

      http://www.bogleheads.org/wiki/Retirement_calculat...

      Many other withdrawal-rate studies are quoted in the BogleHeads.org wiki:

      http://www.bogleheads.org/wiki/Safe_Withdrawal_Rat...

      The original Trinity Study ignored Social Security. Wade Pfau's recent work has looked at Social Security and single-premium immediate annuities to provide a guarantee against total retirement failure (a minimum budget). He's shown that the 4% SWR works quite well once annuities have guaranteed a minimal income.

      His paper is here:

      http://www.fpanet.org/journal/SpendingFlexibilitya...

      and I discuss its advantages for military veterans here:

      http://the-military-guide.com/2012/04/25/how-much-...

      I'm 51 years old and I've been early retired for 10 years. I can confirm that early retirees place a higher priority on their quality of life than on their government benefits. While everyone would like to be well-paid for doing what they love, the fact is that many are unhappy in their employment and would rather save aggressively (and cut their expenses) to retire before their 60s. There are thousands of us discussing the lifestyle and the processes at Early-Retirement.org.

    • pauldeeds profile image

      Paul Deeds 

      6 years ago from Berkeley

      I would recommend using a monte carlo simulator to test different scenarios for your personal situation. That's always going to be better relying on an over simplified rule. This is the one I prefer:

      http://www.flexibleretirementplanner.com/java/Laun...

    • Ari Lamstein profile imageAUTHOR

      Ari Lamstein 

      6 years ago from San Francisco, CA

      Thank you for the thoughtful comment Simone. Yes, the book that I mentioned reading was "Early Retirement Extreme" by Jacob Fisker, which I link to above. It's a good read - after reading the first few chapters you might change your mind about never wanting to retire!

    • Simone Smith profile image

      Simone Haruko Smith 

      6 years ago from San Francisco

      I'm really glad you wrote this Hub, Ari! You had mentioned a book you were reading on early retirement a while back, and I found the concept to be interesting (though if I have my way, I'll never retire). I hadn't heard of the 4% rule- thanks for the introduction! It's good to know that early retirement and the 4% rule aren't meant to be used together ;)

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