If you’ve spent any time on retirement planning, you’ve probably heard mention of the 4% rule. It was developed to help determine how much money retirees could safely take from retirement accounts annually, without depleting their funds.

Summarizing the rule quickly, you can withdraw 4% of your portfolio on day 1 of your retirement. You can then withdraw a similar percentage every year thereafter (the actual dollar amount will change based on remaining balances, of course), adjusting the amount to keep pace with inflation. Done properly, you will have very little chance of running out of money.

The 4% rule has been widely accepted in the early retirement community. This is in spite of the fact that early retirees have much longer retirement lengths than the 30-year assumption used in the rule’s original research. Conversely, though, there is credible new research which suggests that in low interest rate environments, as we are currently experiencing, 4% withdrawal rates are too optimistic, even for traditional retirements.

Whether the 4% rule is gospel truth, too conservative, or too aggressive for retirement planning can be debated. However, there are universal lessons hidden in the 4% rule which are valuable to anyone on the path to financial independence and retirement.

Lesson 1: The Fastest And Easiest Path to Financial Independence Is Needing Less

The 80% Salary Replacement Rule is commonly used by financial advisers to determine retirement income needs. According to the 80% rule, what you need for retirement is tied to what you earn in your working years. If you earn $50,000/year, assume that you will need $40,000/year in retirement. If you earn $100,000/year, assume that you will need $80,000/year in retirement.

The 80% rule works for many people because they spend most or all of their income. However, just because many people live this way does not mean we all should.

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The 4% rule disassociates earning and spending. Let’s think of it another way: using the inverse of the 4% rule, we get the rule of 25. When your investments reach 25 times your annual spending, you are considered financially independent. Now, you would have enough money to withdraw 4% of investments and live exactly as you are.

Your spending, not what you ever earned, determines how much you need to be financially independent. This knowledge can be empowering.

Understanding how much you actually need to be financially independent can, at first, also seem intimidating. If you spend $100 monthly ($1,200/year) for cable TV, you would need $30,000 ($1,200 X 25) in investments to support this expense alone. That number can seem large and difficult to attain, and remember: this would support only $100/month of spending.

However, replacing cable with an online service for $10 monthly would cut this annual expense to $120. To support this expense with investments would require only $3,000.

Saving a few dollars a month does not seem like a big deal at first glance. With this different perspective, though, you can see that not only do you save an extra $1,080 each year. This one decision gives the double effect of reducing the amount needed to retire by $27,000. That is a big deal!

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The effects become quite impactful when applying this logic to bigger ticket items. Supporting a $2,000 monthly mortgage payment in retirement would take $600,000 of investments. However, choosing a home you could pay off before retiring would eliminate mortgage obligations.

Quoting financial independence blogger and writer JL Collins, “Financial independence has two aspects: How much you have and how much you need.” Understanding the 4% rule and its inverse, the rule of 25, should make this clear.

Having enough investments to support a high-cost lifestyle is very difficult to achieve, even for very high earners. However, focusing on needing (and spending) less can make financial independence achievable for nearly anyone.

Related: Money Rules to Ensure a Successful Retirement

Lesson 2: Investment Fees Matter

If you are a regular Dough Roller reader, this should not be news to you. It is a regular theme are here. In fact, you can check out the recent post and podcast inspired by this topic.

John Bogle founded the Vanguard investment group based on this concept. He has written entire books explaining the impact of fees on investment returns. While this lesson can be more fully explained in books, articles, and podcasts, the 4% rule allows for a simple back-of-a-napkin explanation.

Imagine that you spend $40,000/year to live. According to the 4% rule, you need to accumulate a $1,000,000 portfolio to sustain that $40,000 annual spending. However, the 4% rule is an academic exercise and does not reflect investment fees.

If you pay 2% annual investment fees, your $1,000,000 portfolio would cost $20,000. This represents half of what you could safely take from your portfolio. This would leave you with only $20,000 for your spending needs, while keeping your initial portfolio withdrawal at 4%. You would actually have to save $2,000,000, double what you would without fees, to provide your initial $40,000 and pay “only” 2% investment fees while keeping your withdrawal rate at 4%.

Read About 7 Ways to Improve Your Investment Returns

If nothing else drives this point home, the 4% rule should. Investment fees matter!

Lesson 3: Many People Give Themselves No Chance At Financial Independence

In a previous post, I discussed the impact of savings rate on wealth building. The post includes a table that shows the relationship between savings rate and the approximate number of years it would take to reach financial independence. What it comes down to? Most Americans do not save nearly enough to even give themselves a viable chance. It’s near-impossible for them to accumulate 25 times their annual spending, which the 4% rule shows we need to be financially independent when investing in stocks and bonds.

Once we have the means to save enough money, there is then the assumption that we can just blindly put money in our 401(k) or hand things over to an adviser with wildly unrealistic expectations. These scenarios are seen everywhere, such as Dave Ramsey’s “12% Reality.” He writes that “you can expect to make 12% on your investments” using “an investment professional” based on “real numbers.” These ‘real numbers’ assume investing 100% in stocks while failing to account for inflation, volatility of returns, or investment expenses. It does not sound like any real world that I am aware of.

Invest Wisely: How to Determine Your 401(k) Fees

Studies show most investors get substantially less return than the funds they invest in. This occurs because investors make behavioral errors trying to time and beat the market. Adding insult to injury, they pay unnecessary fees and taxes in the process.

While not perfect, the 4% rule gives a realistic expectation of what you can expect to spend living off a portfolio of paper assets, while factoring in real historic returns and accounting for the effects of portfolio volatility. The inverse rule of 25 likewise gives a reasonable estimate of how much money it takes to be financially independent.

If you are using the assumptions of the 4% rule, you should first understand the effects of savings rate on time to financial independence. Be sure you save an amount that gives a legitimate chance at a successful outcome. Otherwise you are dead in the water before getting started.

Next, you should learn to invest in a way that makes these assumptions valid. This means learning about index investing, which aims to deliver market returns while minimizing investment fees and taxes. Even when minimized, these expenses must be accounted for. You should also learn how to avoid the behavioral errors that most investors make that prevent getting market returns.

If you are willing to make an effort to save an appropriate amount and learn to invest in a competent way, the 4% rule can be a very useful tool to help you with your retirement planning. If you are not willing to take the time and effort, the 4% rule is a reality check. It demonstrates that paper assets do not provide a viable path for many people to build enough wealth to become financially independent.

How Will You Use The 4% Rule?

The 4% rule is one of many “rules” found in personal finance. It was developed to determine how much money can be safely taken from retirement accounts annually. You can choose to follow it, modify it, or use a completely different approach for your retirement spending. However, there are some important lessons hidden in the assumptions behind the research that can help everyone that takes the time to understand them as we find our paths to financial independence.

What are your thoughts on the 4% rule and its accompanying rule of 25?In podcast 327, we address misinformation and assumptions about the 4 percent rule to give you a better understanding of how it works.

The post DR Podcast 327: What You Really Need to Know About the 4% Rule appeared first on The Dough Roller.



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