If the goal is to save enough money that at some point you hit a critical mass that is capable of sustaining your lifestyle in perpetuity, you first need to determine how much money is “enough money.” Without knowing this, you do not have a tangible goal to achieve financial independence. For that reason, I want to explore safe withdrawal rates, the 4% rule and calculating and understanding your financial independence (FI) number.
Withdrawal Rate
Withdrawal rate is simply defined as the amount you take out of your portfolio each year expressed as a percentage of your total assets. The amount of your portfolio that you withdraw each year is driven by your annual expenses. Depending upon the presence of income, there are two ways to calculate withdrawal rate. At the most basic level, your withdrawal rate is calculated as follows:
Annual Expenses/Total Portfolio
- For example, if you withdraw $100,000 each year from a portfolio of $2.5MM, you have a 4% withdrawal rate ($100,000/$2,500,000).
When accounting for additional income sources, your withdrawal rate would be calculated as follows:
(Annual Expenses – Annual Income)/Total Portfolio
- For example, if you assume the same $100,000 expenses and base portfolio as the example above, but you also have $20,000 of income, your withdrawal rate is reduced to 3.2% (($100,000 – $20,000)/$2,500,000).
Ultimately, calculating your withdrawal rate is the easy part. The hard part is determining the withdrawal rate necessary to sustain your life while also ensuring you do not run out of money. In order to determine this, you have to determine a safe withdrawal rate.
Safe Withdrawal Rate & The 4% Rule
While withdrawal rate is the percentage you are taking from your portfolio each year, the safe withdrawal rate is the percentage you can withdraw from your portfolio each year and be confident you will not run out of money in your lifetime.
There are many factors to consider when determining your safe withdrawal rate and thus the portfolio size needed to achieve financial independence. In order to simplify this calculation, the FIRE community often cites the 4% rule. The 4% rule is a baseline calculation utilized to determine the portfolio size needed to sustain your spending in perpetuity. Utilizing a 4% safe withdrawal rate assumption, you can determine your needed portfolio size by multiplying your annual expenses by 25 (100/4). This gives you your financial independence or FI number.
For example, if you need $100,000 each year to live, you would need a $2.5MM portfolio. If you need $250,000 each year to live, you would need a $6.25MM portfolio and so forth and so on.
This calculation is imperfect in many ways but it also provides a quick and simple method for determining the portfolio size needed to achieve financial independence. Anyone seeking to achieve FI needs to not only understand what their life costs but also what size portfolio is necessary to achieve FI. The 4% rule makes that calculation very straightforward and easy.
The Trinity Study: The Origin of the 4% Rule
The 4% rule of thumb was popularized by the Trinity Study which confirmed the earlier work of William Bengen. The Trinity Study was originally published in 1998 in the Journal of the American Association of Individual Investors. The article was titled “Retirement Spending: Choosing a Sustainable Withdrawal Rate.” It is nicknamed the Trinity Study because it was written by three professors at Trinity University in Texas.
The intent of the study was to determine portfolio success rates utilizing historic market data. Specifically, the study modeled or back-tested various portfolios using three key factors: withdrawal rate, time horizon, and stock allocation. Portfolio success rates for various withdrawal rate and asset allocation assumptions were calculated for the time period 1926 to 1997. Utilizing 30 year rolling periods, a portfolio success rate was calculated for the various withdrawal rates and stock allocations over various time horizons with the intent of drawing the portfolio down to zero. The results of the updated Trinity Study are outlined in the table below.
- Withdrawal rates are noted across the top and range from 3% – 12%.
- Stock/bond allocations ranging from 100% stocks and 0% bonds to 0% stocks and 100% bonds are on the left.
- Withdrawal timelines are also on the left ranging from 15 years to 30 years.
There were a couple of key take-aways from the study:
- In general, the lower the withdrawal rate, shorter the time horizon and higher the stock allocation, the greater success rate of the portfolio.
- Withdrawal rates greater than 4% reduce the success rate considerably. This is why you see most safe withdrawal rate recommendations between 3% and 4%.
- You can achieve a 96% success rate over a 30 year time horizon if you withdraw 4% from a portfolio of 50% stocks and 50% bonds. This is where the 4% rule was born.
There were several assumptions built into the Trinity Study that cause many to question it’s continued applicability now and into the future. In addition, if you plan to stop working earlier than traditional retirement age, your money will most likely need to last longer than 30 years. In some cases, much longer.
My Take on the 4% Rule
More recent studies lead some to conclude a 3% – 3.5% withdrawal rate may be a better assumption to account for sequence of return risk and longer time horizons. These studies also introduce factors not originally considered in the Trinity Study including but not limited to increased portfolio diversification, variable annual withdrawal rates driven by portfolio performance, asset allocation changes over time, etc.
Early Retirement Now is a popular resource in the FIRE community. He did a Safe Withdrawal Rate Series accounting for a retirement length of 30 – 60 years. The results were relatively consistent with the Trinity Study noting the 4% safe withdrawal rate starts to break down over longer time periods. A 50% – 100% stock allocation with a 3% – 3.5% withdrawal rate seems to be the sweet spot. His results are outlined in the table below. If you want to get into the details and read the entire series, I highly recommend.
When it is all said and done, I consider the 4% rule of thumb as exactly that. It is a rule of thumb. I think it is a great benchmark for those new to the concept of financial independence to calculate their FI number. I personally am more conservative and assume a 3.5% safe withdrawal rate when calculating my FI number. This changes the expense multiplier calculation slightly. Instead of using 25x (100/4) your annual expenses to calculate your FI number, this more conservative withdrawal rate assumes ~ 28.5x (100/3.5) annual expenses. The 3.5% rule is not as catchy and the math is slightly messier but it is what I am comfortable with.
So What Does it All Mean?
If you seek to achieve financial independence, you now have the ability to define a tangible goal. You now have your FI number.
- If you seek to become “work optional” by sustaining your current lifestyle, you simply need to multiply your current annual expenses by 25 or 28.5. This will be your FI number at a 4% or 3.5% withdrawal rate respectively.
- If you seek to become financially independent while also living the lifestyle you seek to achieve, you simply need to estimate your projected annual expenses and perform the same calculation above.
As you may recall from my first post, my reaction as a HENRY first discovering the financial independence movement was similar to a lot of people. Without a basic understanding of the math, I initially believed the amount of money that I needed to achieve financial independence was $10MM+. Once I understood the math, I was able to determine my actual FI number. My actual FI number is ~ $2.8MM assuming no mortgage or rent. This figure assumes a projected annual expense of ~ $100,000 with a safe withdrawal rate of 3.5%. It is important to note this represents my current goal but I still consider it somewhat of a moving target. Like any goal, it is subject to change as life happens. My assumptions of the future and my future expenses may change. The $100,000 annual spend seemed like a good place to start. So for now… I am going with it. I have a goal. I have my FI number.
What’s Next?
Once you know and understand your FI number, it is up to you what to do next. Consider the following:
- To achieve FI, you need to save and invest.
- To save and invest more, you need to increase your savings rate.
- To increase your savings rate, you need to decrease your expenses.
- To decrease your expenses, you need to understand what your life costs and where you spend money that does not align with your values or bring you additional happiness.
As a HENRY, your timeline to financial independence is largely in your control. Your income allows you to spend significant money in areas that you value and bring you happiness while also maintaining a high savings rate. You have the luxury of being able to save for a BETTER tomorrow while still living your BEST today. The decision to go from a HENRY to FIRE is yours and yours alone.
Regards,
– HENRY