If you’re targeting financial independence (FI) or an early retirement, the 4% rule is one of the quickest and easiest tools in your toolbox to figure out how much money you need to retire based on your anticipated expenses in retirement. Since everybody’s retirement number is different, answering the question of when you can retire or are financially independent is very subjective without doing an actual calculation. The four percent rule is a rule of thumb often used by the Financial Independence, Retire Early (FIRE) community to back calculate the financial independence number via the rule of 25. The 4% rule is also a historically and data backed way to forecast how much you can comfortably spend in retirement without running out of money. While it is a simple concept for retirement planning, there are nuances to be aware of based on the assumptions it is built off of. Therefore, it’s important to understand how to apply the 4% rule as well as when it’s not the best or appropriate method. Below, we cover what the 4% rule is, how it’s determined, and the pros and cons of using this method for setting retirement goals.
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What is the 4% rule?
The 4% rule is a rule of thumb in personal finance used to calculate how much money you need to retire, when you can consider yourself financially independent, and how much money you can spend annually in retirement without running out of money.
The allure in the 4% rule lies in its simplicity (though you’ll learn below that you can make it much more complicated). Essentially, you add up all of your investments and then multiply that number by 4%, and that is the amount of money you can spend every year in a 30 year retirement period and not run out of money.
In it’s simplest form, the calculation for the 4 percent rule states that you can withdraw 4% of your investment savings in the year of retirement, then withdraw the same amount every year after (typically adjusted for inflation), and have enough in your nest egg to safely retire.
For example, let’s say that your investment portfolio when you retire is 5 million dollars. You can withdraw $200,000 in your first year of retirement. Assuming a 2% cost of living adjustment annually, you would then be able to allow yourself 2% more annually (so $204,000 the next year, and so on) for 30 years.
At this 4% “safe withdrawal rate,” your income in retirement will largely come from the interest and dividends your investments make, as well as their capital gains, allowing your portfolio to continue to grow and last you through your retirement years.
Historical background and context on the 4 percent rule
The 4% rule was developed in the 1990s by William Bengen after an in-depth analysis of historical data on the stock market, looking back to the 1920s. While the stock market returns over time can average 8%-10% overall, this doesn’t mean that this is a safe withdrawal rate. As we’ve all seen, including in recent years, the stock market has years where it drops, as well as years where overall investments average 20% gains. Withdrawing funds during periods where the stock market is below the average 8% - 10% gains can compound losses, just as compound growth works in your favor over longer periods of time (see our article on how your net worth increases over time). The 4% rule averages out these hills and valleys to provide one consistent withdrawal amount.
Can I really count on the 4% rule?
Some investing experts feel that 4% is too conservative and that it’s modeled for worst case scenarios. Others think with the potential of high volatility in the stock market and with longer lengths of retirement, it might not be conservative enough. As such, you may also hear proponents of a 3% withdrawal rate or a 5% withdrawal rate.
Given that we can’t forecast the stock market decades into the future, there isn’t one right or wrong answer, though there may be one better suited for you. For example, if you are highly risk averse, the 3% rule might be a better fit because it affords you more peace of mind. There’s nothing wrong with that; after all, your retirement should fit your life and goals.
Most financial advisors would agree that this is not a hard and fast rule, and will remind you that while it has been proven to work for many people and is thus a great rule of thumb, it should be used in context and by factoring in your personal financial plan, goals for yourself and loved ones, priorities, and other financial metrics. Therefore it is important to understand the assumptions on which it is based in order to see how the rule applies to your particular situation. Next we will dive deeper into these premises.
Assumptions of the 4% rule
30 years in retirement
When developing the 4% rule, analysts used a model that only looked at a 30-year period for withdrawals.
Life expectancy and the length of retirement both play key roles in determining whether the 4% rule will lead to a safe withdrawal rate in your situation. For example, if you chose to retire early at the age of 45, and then go on to live another 50 years, you may run out of money because of the effects of inflation and other factors. If you love your job and work as a physician into your late 70s, you can probably withdraw at a rate higher than 4% once you retire.
Relies on the money being invested
For those of you that tend to keep a large percentage of your net worth in cash, this will mess with your 4% rule calculation, as this model assumes that your money is working for you in the background to continue to generate returns.
Historic market returns
Depending on when you retire, this could hurt you or help you. If we enter a longer recessionary period where average returns are lower than they have been, taking out 4% a year could result in you withdrawing too much. Conversely, if we have a great decade such as the past decade, the 4% rule could be overly conservative, and you will likely not Die With Zero, leaving a lot of money unused at the time of death.
Assumes steady spending
Most of us will attest to the fact that our budgets as physicians are not the same every year. If you have a year during retirement where you decide to take that bucket list vacation or where you buy a new car or vacation home, you will likely have to withdraw more. While slight variations are likely not too big of a deal, a major outlier, particularly early in retirement, could mess with your calculations.
Asset allocation
Along with inflation, another assumption to note is that the 4% rule is based on a portfolio allocation of 50% in stocks and 50% in bonds. Our guess based on what we see in the physician communities is that this may not be the case for your portfolio, now or in retirement. Different asset allocation strategies, such as common three-fund portfolio allocations will adjust how accurate the 4% rule can apply to your situation. For example, if you have a 80 stock/20 bond portfolio, a 5% rule might be a better model (assuming no major downturns in the market). If you have a 80 bond/20 stock portfolio, you may want to consider the 3% rule instead.
Understanding and applying the four percent rule
Does the 4% rule take into account other revenue streams or income?
The 4% rule provides a steady stream of income that can be spent without running out of money, even if you completely stop working in retirement, without taking into account the money you may get through Social Security. Many physicians don’t elect to cut out all income streams at once, choosing instead to transition into retirement by switching to part time or locums work, or by having other income streams through real estate or other side gigs they enjoy. They may also have residual income related to their private practice partnerships such as ownership of medical office buildings.
Does the 4% rule take into account taxes or investment fees?
No. Therefore, if your financial advisor or investment platform charges a large amount of fees or you carry a lot of types of investment products that have high fees, that will erode away into the amount of money that is building in the background, throwing a kink into your 4% rule assumptions. It also doesn’t include the taxes you will have to pay on any money that is withdrawn, including capital gains taxes or income taxes on your tax deferred retirement accounts. If tax rates change significantly, this could also drastically affect how much actual spending money you have from your projected number.
The 4% rule and inflation
Inflation can also play a role in understanding and applying the 4% rule. In general, the safe withdrawal amount is typically adjusted for inflation annually, though some believe in keeping the withdrawal amount fixed, though this loses purchasing power over time.
Diving even deeper are discussions about whether to use a set flat average inflation rate, such as 2%, or if you should adjust your withdrawal amount annually based on the current inflation rate.
Again, there is no one “right” method to using the 4% rule. Adjusting based on actual inflation rates can make your projections more accurate, but it also requires you to update your calculations every year, while a standard 2% inflation model can forecast your numbers throughout retirement now.
Using the 4 percent rule to determine if you’re ready to retire, and the rule of 25
Let’s look at a specific example to see the 4% rule at work. If you have a retirement nest egg of $2,500,000 between all your different retirement accounts (HSA, 401k, IRA, taxable brokerage account, etc.), the 4% rule states you could safely withdraw $100,000 a year in retirement (plus adjustments for inflation as discussed above).
If your current lifestyle requires $150,000 in expenses, then you would need to continue to save before hitting your retirement savings goal.
The Rule of 25, which is the inverse of the 4% rule, could then help you determine how much you need in retirement. Using this method, you would take your target $150,000 annual income in retirement and multiply it by 25 to determine your FI number, which would be $3,750,000.
Remember also that your expenses, and thus your required income, in retirement will likely look different than todays. For example, once you are financially independent and quit working, you will no longer need to pay for disability insurance or life insurance. You may also have your house paid off and won’t need to budget for a mortgage payment as part of your 4% rule annual retirement income.
Pros of using the 4% rule for retirement planning
It’s easy to calculate and understand. While there are ways to add complexity into the 4% rule, such as different adjustments for inflation and accounting for external retirement income, overall the 4% rule is simple to understand and calculate. It can be a great way to help investors, especially new ones just starting out, plan for retirement.
Offers a concrete savings goal to aim for. We often see questions in our physician online community from doctors wondering what is a good savings rate or how to determine what they need to do to retire. The 4% rule can help them calculate their ideal FI number for retirement, which they can then use to figure out how much they need to be saving in order to reach their specific retirement goal.
Provides a predictable, steady income projection for retirement. The 4% rule can help you gauge a steady annual retirement income you can plan your retirement budget around. While there may be certain splurges you’ll want to plan for in retirement, such as once in a lifetime destination travel, a child’s wedding, and new vehicles, this rule of thumb can help you model your day-to-day life.
Accounts for market volatility to help protect you from running out of money in retirement. While the 4% rule isn’t a guarantee, it’s a researched and well defined model based on past data that is popular for a reason. In many circumstances, it’s a conservative estimate for retirement to help prevent you from outliving your nest egg. We cover some considerations to take into account below.
Cons of using the 4% rule for retirement planning
Doesn’t respond to changes in the market. While in general the 4% rule is based on historical data of market changes, it is rigid and does not account for situations such as recessions, where you may want to avoid drawing down funds so you don’t have to capitalize on losses. The 4% rule also doesn’t adjust should future market averages differ from historical ones used.
Only applies to a set retirement length of time. When the 4% rule was originally modeled, it assumed a retirement length of 30 years. While three decades is a long time, if you live into your 90s, you would need to wait until your 60s to retire to fit within the ideal situation for the 4% rule. And since we don’t know how long we’ll live for, this can leave a significant amount of uncertainty, especially for physicians who are hoping to retire early or to cut back on their clinical work to focus more on family, side gigs, and hobbies sooner.
It does not account for additional income streams outside of retirement accounts. The 4% rule only includes assets and income invested in the stock market. Many of our physician members enjoy side gigs such as real estate investing that provide additional income streams beyond their full-time jobs. This income often lasts into retirement, especially with rental properties, but isn’t factor into the 4% rule equation. Neither is the equity in assets outside of your retirement accounts, such as your rental properties. These can change your retirement planning and needs significantly, depending on your overall asset portfolio.
Doesn’t leave room for large unplanned expenses or lifestyle changes. As we mentioned above, you might want to help pay for a child’s wedding or treat the extended family to a vacation. The 4% rule doesn’t account for these expenses unless they fit within the annual withdrawal amount, which large ones typically won’t. While this doesn’t mean you can’t still use the 4% rule or rule of 25 as a baseline, you’ll have to adjust your numbers for these types of expenses. This can be hard to predict for unknown expenses, such as long-term care for you or your spouse.
Additional considerations when using the four percent rule
A few additional things to keep in mind when using the 4% rule or any other retirement forecasting method:
Many retirement accounts, such as traditional IRAs and traditional 401(k)s, have required minimum distributions (RMDs) that can affect what you have to withdraw; if you have large balances in these accounts, it can change your numbers
Along with additional income streams such as real estate income, don’t forget to take into account additional retirement sources, such as Social Security, pension, defined benefit cash balance plans, and annuities
The 4% rule doesn’t automatically account for taxes or investment fees, so remember you’ll have to pay these out of your annual income calculation
Conclusion
The 4% rule, and its related rule of 25, are great guiding principles to help you determine how much you will need in retirement and thus how much you should be budgeting for investing now. They aren’t, however, perfect models for determining when it’s time to retire.
The further out your projected retirement, the more uncertainty inherent in your situation and thus the less reliable models like the 4% rule are. This isn’t to say to disregard the 4% rule–it can be a great place to start. But it’s always important to look at your specific situation and goals when determining the best approach to financial independence. Hardly anything in life goes exactly as planned, and a willingness–and ability–to be flexible can help you ride both the ups and downs of the stock market and in life. It’s a good idea to reassess your plan at least once a year to make sure it still aligns, making changes as necessary when large life events occur.
Retirement resources for doctors
If you are overwhelmed and don’t know where to start, or just need some professional guidance to help you fine tune your retirement planning, we recommend reaching out to a financial advisor who works with physicians to help you map out a financial plan.
Our partner Empower also offers free retirement tools and trackers to help with your long-term financial forecasting as you work toward your retirement goal.
Note: Empower Personal Wealth, LLC (“EPW”) compensates us for new leads. We are not an investment client of Empower Advisory Group, LLC.
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