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Optimizing The 4% Rule
How To Backtest Your Retirement Portfolio
(My book “Optimizing the 4% Rule” is available on Amazon now. It covers many aspects of designing and building a financial independence portfolio. Grab a copy if you are interested.)
If you are like me — needing to see with your own eyes where 4% comes from — so you can believe and one day have the courage to pull the trigger (to leave the workforce in general) with peace, this may be the article for you.
The approach discussed in this article is not novel but has existed for a long time. However, surprisingly, I realized none of the people I talked to knew about this, even the people who are preparing to retire early. This is why I wanted to write about it.
Get ready! A lot of numbers are coming.
What the heck is the 4% rule?
People who are into the FIRE (Financial Independent Retire Early) movement, more or less heard about the 4% rule:
In the first year of your retirement, you can safely withdraw the amount of no more than 4% of your stocks + bond portfolio. For each subsequent year for 30 years, you can continue to withdraw the same amount with inflation adjustment, without depleting your portfolio.
For example, if you have a $1 million portfolio -
- Year 1: you could spend up to $40,000 ($1,000,000 x 4%).
- Year 2: if the inflation were 2%, you would adjust the Year 1 amount of $40,000 by 2%. In this case, you would withdraw $40,800 ($40,000 x 1.02). In a very rare case of deflation, say -2%, you would withdraw $39,200 ($40,000 x 0.98).
- Year 3: if the inflation were 2%. you would adjust the Year 2 amount of $40,800 by 2%. In this case, you would withdraw $41,616 ($40,800 x 1.02)
Where 4% is from
In 1994, by conducting a number of empirical simulations of historical market behavior, William Bengen concluded that a retiree could withdraw up to 4% annually from their portfolio, without fear of outliving their money. The suggested portfolio mix is often 50% stocks + 50% bonds or 60% stocks + 40% bonds.
