The 4% Rule

The 4% rule

4% is the amount I can withdraw from a retirement portfolio while expecting it to last through a normal 30 year retirement. This figure was discovered based on the Trinity Study, which evaluated numerous 30 year investment periods in the past to determine what a safe withdrawal rate would be. Based on that study, I will have a 96% chance of having my entire portfolio intact after 30 years. Past performance does not indicate future returns so it is not a for sure thing, but it is a good estimate to use. I could use a higher percentage if I were confident that my investments would earn a higher return, or I could use a smaller and more conservative percentage. To keep it simple, however, I choose to use the typical 4%. This 4% rule also accounts for inflation.

The 4% rule = 25X my annual withdrawal amount

Another way to understand the 4% rule is to realize my retirement nest egg needs to be 25 times bigger than the amount I plan to spend from it on an annual basis. Let’s look at some simple numbers. If I want to withdraw $40,000 every year from my retirement portfolio, I need to multiply that $40,000 by 25. This means I need to have $1,000,000 invested in a reasonable portfolio to withdraw $40,000 every year. 4% of $1,000,000 is $40,000.

Other retirement income sources

I also need to account for any other income sources during retirement such as Social Security, my pensions from my reserve retirement and my GS job, any real estate income, etc. This money would be in addition to the hypothetical $40,000 I am withdrawing from my retirement accounts.

Begin with the end in mind

Knowing the 4% rule allows me to begin with the end in mind. I need to estimate how much I need to withdraw during retirement, multiply it by 25, and start accumulating wealth towards that goal. What age do I want to retire? How many years does that leave me to save? Answering those simple questions will tell me how much I need to save every year in order to reach my goal. To keep things simple for this calculation, I could use 4% as a reasonable rate of return on the money I am investing.

Hypothetical numbers

The excel formula would look like this. Future Value at retirement = FV(4%,30,-10000,0,0). To explain these numbers: 4% is the expected return. 30 is the number of years I plan on working before retirement. -10000 is the amount I plan to invest every year. 0 is the amount I already have in the retirement account. The last 0 indicates I will be investing the money at the end of every year, which is the default scenario.

Using the above hypothetical numbers, my nest egg after 30 years of investing $10,000/year with $0 currently in the account at a 4% return would reach $560,849. If I invested $20,000/year but kept all other variables the same, I would have $1,121,699. If I invested $10,000/year but could increase my rate of return to 5%, my nest egg value would be $664,388. I can play with the numbers to determine how long I have to work and how much I need to invest in order to reach my nest egg goal. This is critical because the amount of my nest egg will determine how much I can withdraw every year without decreasing the amount of my retirement portfolio.