No matter what you read on early retirement, they all say the same thing: follow the 4% Rule.
The 4% Rule was invented in the 90’s on how much you could safely withdraw in retirement.
For years this ‘rule’ has been taken as gospel: if you want to safely retire, you must follow it.
However, the inventor of the 4% Rule has come out saying that the 4% Rule needs updating:
The inventor of the 4% Rule, Bill Bengen, says that the 4% Rule has been ‘too conservative’.
He says the 4% Rule was treated ‘too simplistically’ and it was for ‘worst case scenarios’.
Based on data, he says early retirees would be ‘safe’ with a withdrawal rate of around ‘5%’.
In this post, I talk about the history of the 4% Rule and why it’s being updated to the 5% Rule.
I also talk about what it means for early retirees regarding investment goals and years to go.
Finally, I discuss which options may be best for you, and where to find out more information.
The History of the Infamous 4% Rule
The 4% Rule comes from a study, called the Trinity study, conducted into retirement planning.
Bengen and his team wanted to find out, by starting with retirees and their entire life savings, how long their money would last during their retirement, and what percentage they would need to withdraw each year to live off leaving the rest of their money invested in index funds.
They ran through 100s of scenarios: what if you had £500,000 and needed £50,000 to live off each year (10%) or what if you had £1,000,000 and needed £40,000 to live off each year (4%).
After years of research, he came up with a withdrawal rate that had a 95% chance of success.
I’m sure you have guessed it: 4% – and this has been used for retirement planning ever since.
In summary: by having a pot of money and withdrawing 4% a year to live off and leaving the rest invested, you have a 95% chance of that money lasting throughout all of your retirement.
Why has the 4% Rule changed?
You may think this is a big step for Bengen to go from 4% to 5%. However, this isn’t the first time he’s come out with an update. In 2006, he said that the 4% rule could be the 4.5% Rule.
He says the 4% rule has been treated ‘too simplistically’ and was the ‘worst possible scenario’.
It was derived for someone retiring at the worst ever time in modern history: October 1968.
Someone retiring at this time had to survive a bear market and high inflation, like these days.
Someone retiring then would have been ok if they withdraw 4% a year, adjusted for inflation.
However at other times, with low inflation and a bull market, retirees could withdraw more.
In fact, he says that the average safe withdrawal rate has been around 7% and as high as 13%!
Based on current times, Bengen says that retires can start with a safe withdrawal rate of 5%.
This is actually what he uses himself – and if Bengen uses it, then that sounds good to me!
What does this mean for our Investment Portfolio?
Traditional we’ve been told that the size of the pot we need to save is based on the 4% rule.
For example, let’s say that in early retirement, you want to have an income of £3,000 a month.
That means that per year, you want to have an income of £36,000 i.e. £3000 x 12 to get £36k.
To determine your pot amount, we’ve been told to multiply it by 25 i.e. (1/4) x 100 = 25.
Therefore, you would need £900,000 i.e. £36,000 x 25 to have a monthly income of £3,000.
Now let’s follow this same example but instead of using the 4% rule using the 5% rule instead.
Let’s say you need the same monthly income of £3,000 and therefore a yearly income of £36k.
However, instead of multiplying this amount by 25, we multiply it by 20 i.e. (1/5) x 100 = 20.
This would give us a required portfolio amount of £720,000 – that’s a difference of £180,000!
Using the 5% rule, you’d need £720k instead of £900k to have a monthly income of £3,000.
How many years does that mean until Early Retirement?
By using the 5% rule instead of the 4% rule, it means you need £180k less in your savings pot.
Therefore the question is – how many years are you saving until you reach early retirement?
Take a look at the table above. In this example, I’ve assumed that you invest £1,000 a month.
That means that over the course of a year you would have invested £12,000 in contributions.
I’ve assumed a yearly return of 10%. This is an average; some years higher, some years lower.
So the question is – how many years would it take us to reach our new amount of £720,000?
As you can see from the table above, it would take us just over 20 years to reach £720,000.
As you can also see, it would take just over 22 years to reach £900,000 – a 2 year difference.
You may be thinking – huh, that’s quite surprising, I was expected more of a bigger difference.
However the good news is – your investments really start to compound after a certain time.
Which Withdrawal Rate will you use?
After reading this blog article, you might be feeling a bit confused as to which ‘rule’ to follow:
- At first, you may have been super excited to learn about the 5% Rule and having to save less.
- You may also feel disappointed knowing it’s only a 2 year difference between £720 and £900k.
- Knowing your money compounds faster over time, you may wait until you reach £1 million.
Whatever rule you decide on, the key thing is to start saving and investing as soon as possible.
Whether you wait 20 years or longer, you’ll still be able to retire earlier than retirement age.
To find out more about the 5% rule, check out Conserving Client Portfolios during Retirement.
In his book, Bengen talks about the ground-breaking research into early retirement planning.
Are you on the path to early retirement? How is it going? Please share in the comments below.
If you want find out more on early retirement, check out all my articles on early retirement.
