The 4% Rule
This rule is really famous in the FI/RE movement, and I would like to try to explain it to you guys today. The 4% Rule is a simplified guideline that to see much how much a person can withdraw from their investment portfolio (retirement accounts, brokerage accounts, etc.) without ever running out of money for a certain period of time.
People, from I read and listen to, use this to find a base line for how much they have to save for retirement by taking their yearly expenses and multiplying by 25. But why 25 if it’s the 4% rule? Well, I’ll show the math below using yearly expenses of $35,000 dollars a year.
100 % / 4 % = 25
$35,000 (Yearly Expenses) x 25 (25 from above) = $875,000 (Amount in the Market to Retire)
Note: “Amount in the Market” is not the same as “Net worth”, just remember that.
With the above you can just get a sense of what the definition of the 4% rule is, if you want to be a nerd and go over the study with me read below, but I won’t blame you if you don’t want to LOL.
The Trinity Study
The Trinity Study (I actually read this whole thing because finance :)) was a study by three professors of finance @ Trinity University (Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz) to see how long an investment portfolio would last using historical data that would for go back years from December 1997.
The outcomes of the study were suppose to tell us the chances of your portfolio running out of money before a certain timeline ends. (Timelines explained below)
1) An investment portfolio would be a success if there was ANY money left over in it after the different time lengths (15 years, 20 years, etc. you get the picture).
2) An investment portfolio would fail if you run out of money and have to go back to work because you’re screwed. (I’m afraid of this, so this is why I think “Lean” FI|RE or better is the way for me.)
IT’S IMPORTANT TO NOTE: THIS STUDY DOESN’T TELL YOU HOW MUCH OF YOUR INITIAL PORTFOLIO YOU HAVE LEFT OVER AFTER THE TIMELINES, IT’S JUST SUPPOSE TO TELL YOU WHAT THE CHANCES ARE OF YOU HAVING MONEY LEFT OVER AFTER THE TIMELINE ENDS. (I got this mixed up the first time I read this, but I was never a good academic to begin with)
Why they had different year timelines? (15, 20, ….. 30 years)
The professors took into consideration that not everyone will retire at the age of 55, in fact, they seem to think that some people would like to retire at 70. (Professors apparently tend to stay around for a while, tenure is a hell of a thing). Then they accounted for the average life expectancy and came up with the shortest amount of years an average person could probably retire on and just extended that out in 5 year increments until they reached 30 years. Because if you retired at 55 then at about 85 you can probably expect to kick the bucket sometime soon. (Gruesome!!!), but at the very least you account for retirement and didn’t have to work your whole life (hopefully).
The Math
I’m just going to pull this directly from the study… (NOTE: I DON’T KNOW HOW TO SUBSCRIPT IN SQAURESPACE)
Vt =((Vt-1)(1+Rt))-(Wt)
in which “Vt” is the remaining value of the portfolio at the end of month t, “Vt-1” is the value of the portfolio at the beginning of the month net of the previous month’s withdrawal, “Rt” is the rate of return on the portfolio for month t, and “Wt” is the amount withdrawn from the portfolio at the end of the month.
Basically, what they’re trying to say is that every month you take what you have left over (Vt -1) in your portfolio, give you what your portfolio would make that month (1+Rt) [because investments still make money during the month], and subtract what you take from all of that [AKA what you withdraw] (Wt). And that is what you have for the next month (Vt)
That took me a couple times to read and understand WTH they were doing. So hopefully, the above is easier for you to follow. (I has college edumaction!!!)
Lastly, they do some fancy calculation to account for inflation, but seriously I’m not smart enough to put it in simple terms and the above equation hurt my head. So let us just say, this study accounts for inflation too and move on. LOL
Results
There are a few charts in the study, (you can look yourself) that show you the results of their findings with different levels of asset allocation (meaning did you have Stocks and / or Bonds in your investment portfolio. OLD SCHOOL!! what about real estate homies?)
We’ll just look at one of the charts. If you look at the chart above, “Annualized Withdraw Rate as a % of Initial Portfolio Value” just means how much of your principle (AKA left over money in your portfolio) you are taking out every year. The Year rows just say how long you are retired for.
Where the year rows and the % columns meet, that’s the success rate of your money never running out before you end your retirement.
Examples from above,
See all the “100”s in the 3% column, that means that if you took out 3% of your portfolio each year, you would out last all the years on the left side and still have some money left over (I don’t know how much left over, but you got some money left over) every time.
See the 3 “98”s in the 4% column? That means 2% of the time your money will probably run out before you hit the 20 years, 25 years and 30 years of retirement and if you only have stock in your portfolio. However, if you diversify a little bit you are good the rest of the time.
Conclusion
Any column that has all hundreds in their results, means it’s probably safe to take out that much percentage of your portfolio every year without ever running out of money. This means that you have a 100 percent chance to not run out of money before you end your retirement given the years on the left side.
NOTE: IF I TOTALLY READ THIS WRONG YOU GUYS NEED TO LET ME KNOW IN THE COMMENTS BELOW…. I DON’T WANT TO LOOK LIKE A FOOL HAHA, BUT MY BUDDY AND I CAME TO THE SAME CONCLUSION AND HE WAY MORE CEREBRAL THAN I AM… soooooooooooo…. I feel like I’m safe????…. (FAMOUS LAST WORDS LOL).
- M
What about Today?
Some people smarter than me ran the simulation and coded it up for you here. <Click Me>
Here’s a cool little calculator that buddy of mine above told me about it’s pretty cool go ahead and play with the numbers. <Cool Little Calculator>
Go ahead and check out their finding’s it’s pretty cool.