The 4% Rule: How Much Money Do You Need to Never Work Again?

Figuring out how much money you’d need to never work again is difficult for one simple reason: You don’t know how long you’re going to live.

If you knew you were going to live 10 more years and can get by on a budget of exactly $40,000, the math is simple:

$40,000/year x 10 years = $400,000.

If you live more than 10 years, you’re in trouble.

Of course, that was assuming the money was just sitting there waiting for you to spend it. What would happen instead if you invested your nest egg in the stock market?

Here’s where things start to get complicated. Too complicated to fully cover here. But we can rely on the rigorous studies of others and crunch some simplified numbers of our own to help us answer this question.

The Power of the Stock Market

Let’s use a way-too-simplified illustration to show why investing our nest egg in the stock market is such a good idea.

We’ll pretend you make $65,000 a year after tax and only spend $40,000. The remaining $25,000 you faithfully invest in the stock market where you earn 7%. Here’s what you would accomplish in just 15 years:

Nicely done. You build a nest egg over $672k in just 15 years. Even better, under our generous assumptions, you’re set for life.

This is because you only need to spend $40,000 a year. Your nest egg is earning 7% per year. At a balance of $672,201, your portfolio is earning $47,052 a year.

You could retire indefinitely, pulling out $40k a year and your portfolio would keep growing:

As you can see in the chart, your growth comes to a screeching halt when you begin withdrawals. But compound interest slowly takes over again and your portfolio shoots to the moon. The longer you stay retired, the wealthier you get.

Clearly, we’re at least on the right track.

But by now, you might have noticed a problem: How do we know the market will return 7%?

Well, we don’t. But there’s actually an even bigger problem.

The Problem With the Stock Market

If the stock market gave us predictable returns, we would be all set. Unfortunately, the market doesn’t look like the smooth graphs I’ve presented so far. Here’s the historical performance of the S&P 500, an index that roughly represents the stock market as a whole:

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The overall direction is what we want, but that is one bumpy ride.

Do those bumps in the road actually matter if the market returns the equivalent of ~7% per year in the long run? Yes. The bumps in the road matter a lot.

To borrow a simplified example from Michael Kitces, imagine you have a nest egg of a million dollars and the market returns -50% and +100% the next two years. It doesn’t matter what order these returns happen:

Scenario 1 (Good Returns First)

• Year 1: $1,000,000 +100% = $2,000,000
• Year 2: $2,000,000 -50% = $1,000,000

Scenario 2 (Bad Returns First)

• Year 1: $1,000,000 -50% = $500,000
• Year 2: $500,000 +100% = $1,000,000

If you cut something by 50%, you are multiplying it by .5. If you increase it by 100%, you are doubling it (i.e. multiplying it by two). The order never matters:

• 2 x .5 = 1
• .5 x 2 = 1

But if you are adding or taking away money, the order starts to matter.

Lets say you take out $500,000 after the first year. Here’s how the math works now:

Scenario 1 (Good Returns First)

• Year 1: $1,000,000 +100% = $2,000,000
  • $2,000,000 – $500,000 = $1,500,000
• Year 2: $1,500,000 -50% = $750,000

Scenario 2 (Bad Returns First)

• Year 1: $1,000,000 -50% = $500,000
  • $500,000- $500,000 = 0
• Year 2: 0 +100% = 0

This is an extreme example of sequence of returns risk. This is what makes calculating the amount needed for retirement so tricky.

Part of the Solution: Asset Allocation

One way to fight the scourge of sequence of returns risk is by diversifying our portfolio across asset classes. Asset allocation is important enough that it deserves its own post, but here’s the basic idea:

If only part of your money is in the stock market, only part of your money is exposed to the stock market’s volatility.

But wait, it get’s better.

Let’s say you choose to put half your money in stocks and half in bonds. As we just covered, if stocks have a terrible year only half your portfolio gets hit. But the other half could have very well gone up in value. Now to get back to a 50/50 split, you can sell some bonds to get the money to buy stocks.

This strategy provides a powerful layer of protection to our portfolio, but how has it held up over time? Let’s look to some more in-depth research to find out.

Asset Allocation The Simple Way: How to Protect Your Wealth

The Trinity Study

Our journey starts with a humble paper published in 1998 by three finance professors from Trinity University. The paper was called “Retirement Spending: Choosing a Sustainable Withdrawal Rate,” but became known as “The Trinity Study.”

This study looked at the concept of portfolio success rates for various withdrawal rates.

The portfolio success rate was the percentage of times a given portfolio would have survived in various historical conditions.

The withdrawal rate was the percentage of your portfolio that you withdrew in your first year of retirement.

The researchers analyzed a host of different scenarios. Here are some of the variables they manipulated to come up with the various situations they analyzed:

• Retirement length (e.g. 15 years vs. 30 years)
• Withdrawal rate
• Constant withdrawal rates vs. adjusting for inflation
• Different mixes of stocks and bonds

The 4% Rule

Out of all the results of the work, one finding became famous.

An initial withdrawal rate of 4% adjusted upward yearly for inflation from a portfolio of stocks and bonds only failed to last 30 years in two of the starting years analyzed (1965 and 1966). Historically, the 4% withdrawal rate worked out 95% of the time.

It’s unclear why 4% was seized on, especially when there were situations that showed a 100% success rate. One reason might be that an earlier study by William Bengen indicated that in the worst-case historical scenario, a 4.15% withdrawal rate was the highest safe withdrawal rate. This might be the real origin of the 4% rule.

It might look confusing that Bengen’s 1994 study found that 4.15% was historically the smallest safe withdrawal rate when the Trinity study said that a withdrawal rate of 4% failed twice, but according to Wade Pfau, it’s due to the fact that different kinds of bonds were used in he two studies. Bergen’s 1995 study used intermediate term government bonds. The Trinity Study used long-term, high-grade corporate bonds

Criticism

Like you might expect, there are a lot of criticisms of this study and the 4% rule. Here are a few notable ones:

• The kind of bonds used in the study may not be optimal for retirees
• Following the rule blindly regardless of market conditions can be dangerous
  • e.g. if we enter a bear market immediately after you stop working, you’re probably in trouble
• The study only tells us about historical conditions, not future ones
  • One notable difference: we live in a time of very low interest rates, which has implications for bonds

The Upside of the 4% Rule

If you’re like me, your brain zeroes in on the 5% of the time the 4% rule didn’t work and ignores the 95% of the time when it did.

Is there reason to be optimistic?

As Michael Kitces reminds us:

• For any given historical period, the effective initial withdrawal rate of a 60/40 stock-to-bond portfolio has always been in the range of 4% to 10%
• The median safe initial withdrawal rate for all time periods is about 6.5%
• 90%+ of the time following the 4% rule would have resulted in a bigger portfolio 30 years into retirement than you had at the beginning
• 2/3 of the time you would double your initial principal after 30 years
• The median portfolio 30 years into retirement is 2.8x the starting principal
• In 1/6 scenarios the initial principal increases 5x after 30 years

Again, all of this is based on what happened in the past, not what will happen in the future. But it’s still encouraging because it shows that the strategy can survive an enormous array of real-world challenges.

How Do You Know Which Scenario You’re In?

The key to knowing if you’re in the dream or the nightmare is to pay close attention to what happens in the years after you stop working.

The early years are the critical make-or-break time period. We can illustrate this with a simplified example.

Let’s pretend that You are retiring today with a million dollar portfolio and will be spending $40k per year. Even though the 4% rule recommends a combination of stocks and bonds, you go with all stocks. Let’s also pretend that over the next 30 years, the stock market is going to have one good decade, one really good decade, and one bad decade.

We’ll assume the following annual returns for each decade:

• -5% for the bad decade
• 7% for the good decade
• 20% for the really good decade

Remember, this isn’t a realistic guess of what might happen, it’s just to illustrate the math.

We can put these three decades in any order, but what we’ll notice is bad things happen when the bad years come first.

The Nightmare Scenario

For instance, the nightmare scenario sequence is bad, good, really good:

The simple way of describing what happened is that the combination of yearly 40k withdrawals and 5% losses depleted the portfolio to the point where there was too little principal to recover when the bear market ended.

Scenario #2

In contrast, the second worst scenario (bad, really good, good), isn’t nearly as bad:

The portfolio got hit hard initially, but was saved by a raging bull market of yearly 20% returns.

It’s worth noting that in this scenario, you started with a million dollars, spent more than a million, and somehow have half a million left after 30 years. That’s pretty incredible.

The Dream Scenario

Let’s skip some of the other combinations and go to the dream scenario (really good, good, bad):

Two crazy observations about this chart:

• A different sequence of returns has taken us from running out of money in year 20 (the nightmare scenario) to having 5x our initial investment by year 30 in the dream scenario
• In absolute terms, this scenario actually suffers the biggest losses: The portfolio peaks at $9M but the 5% losses drag us down to $5M for a total loss of $4M

For the purposes of absolute growth or decline, returns are most significant when your portfolio is largest. But in order for your portfolio to grow, it can’t be decimated early by a combination of withdrawals and negative returns.

Remember, these scenarios aren’t “realistic” in the sense that it’s hard to imagine ever having ten straight years of 20% returns. But we’ve already seen that real historical conditions could have produced 5x portfolio growth with the 4% rule.

Calculating the 4% Rule

Using the 4% rule to estimate how much money you need to never work again is pretty simple. All you need to know is how much you plan on spending that first year.

So if you want to spend $40,000, the math is $40,000/.04 = $1,000,000

Since 4% is 1/25th of 100, you can also think of the 4% rule as the 25x rule. Once your portfolio is 25x your annual spending, you might be ready to walk away.

Never Work Again, or Find Work You Love?

There’s a contradiction inherent in the idea of saving enough to never work again. Anyone driven enough to pull it off isn’t going to be happy sitting on a beach in Mexico drinking tequila for the rest of their life.

One way to think about having enough money to never work again is that you are “retired.” Another way to think about it is that you are financially independent. You’ve gained freedom and autonomy because no one can ever again force you to do something because you need the money.

You might still do things that make money. This is a huge win, because any amount of active income greatly decreases the chances of your portfolio failing.

Having the Courage to Walk Away

As we’ve seen, there are no guarantees when it comes to the future. Just because something worked in the past doesn’t mean it will keep working in the future.

If you are going to walk away from the work force before you’re forced out, it is going to take some amount of courage.

The 4% rule isn’t the perfect answer to how much money you need to never have to work again, but perfect answers don’t exist. The people who succeed are the ones who take decisive action based on sound principles despite the presence of crippling levels of uncertainty.