Those interested in financial independence are likely familiar with the 4% rule. The rule comes from an influential 1998 study (the Trinity Study) that set out to determine safe withdrawal rates for retirees, but was later popularized by financial independence blogger, Mr. Money Moustache (aka Pete Adeney).
The idea of 4% rule is simple:
Assume the S&P 500 will return 7% – 10% on average each year over a long enough period of time (20+ years).
That means you could withdraw 4% of your S&P 500 stake, leaving remaining 96% to continue to grow. Theoretically you could continue to do this, every year, until the end of time.
To put it another way: imagine you have a money tree. You can pull 4% of the leaves off the tree each year and the tree will continue to grow and give you new leaves that you could then pull off in future. Be careful, if you pull too many leaves off your tree, the tree will die.
But what if 4% is too many leaves? What if the tree (stock market) doesn’t continue to grow at 7% – 10%? Then you’d be in big trouble.
That’s why I prefer the 3% rule. It leaves (no pun intended) more of a cushion in case things don’t go according to plan. Planning for the unknowns is important when you’re talking about making a decision as big as ending your career.
Ben Felix, portfolio manager at PWL Capital, has some interesting things to say about this topic:
The biggest insight I found in this video is that retirement spending should actually be considered variable and not fixed.
For example, some years you may need to withdraw 5%, but some years you may need to only withdraw 3% depending on your spending and income.
So how much do I need to retire?
If your “FI Number” – the amount of money you need to live every year – is $40,000 then you’ll need need to have $1,333,333 invested if you plan on using the 3% withdrawal rate.
“But what happens if I decide to go with 3% instead of 4% and the stock market continues to return 4% – 7% each year?” My guess is you’d sleep better at night knowing you have more money than you actually need.
This article is part of the Winchell House Original Articles series.
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