The 4% rule is a commonly used guideline in the context of FIRE (Financial Independence, Retire Early). The rule helps folks figure out how much they can safely withdraw from their retirement savings each year while aiming to make sure that their money lasts throughout their retirement.
Here's how the 4% rule works:
Initial Portfolio: When you retire, you should have accumulated a portfolio of investments, which could include stocks, bonds, real estate, and other assets. The starting point is determining the total value of your portfolio at the time of retirement.
Annual Withdrawal: According to the 4% rule, you can withdraw an initial 4% of your retirement portfolio's value in the first year of retirement. This withdrawal is intended to cover your living expenses for the year.
Inflation Adjustment: In the following years, you adjust your withdrawal for inflation. This means you increase the withdrawal amount by the rate of inflation to maintain your purchasing power over time. (Historical inflation rates can serve as a guide for this adjustment.)
Annual Reassessment: Each year, you reassess your portfolio's value and adjust your withdrawal accordingly. If your portfolio has grown, your annual withdrawal will also increase. If it has decreased, your withdrawal might need to be adjusted downward.
Success Rate: The 4% rule is built on historical data and studies of market performance. It is designed to provide a high probability (usually around 90%) that your retirement portfolio will last for 30 years or more, given average market conditions and inflation rates.*
*If you're a nerdy nerd that likes to review the studies on this, you might be interested in first looking at the "Trinity Study", or review this article on the study's data. I also recommend Mr. Money Mustache's famous post.
It's important to note that the 4% rule is a guideline, not a strict rule. Market fluctuations, unexpected expenses, and changes in personal circumstances can impact the sustainability of your withdrawals. Additionally, the rule assumes a balanced portfolio of stocks and bonds. Here's a simplified example to illustrate how the 4% rule works:
Retirement Portfolio: $1,000,000
Year 1 Withdrawal: $1,000,000 * 0.04 = $40,000
Inflation: 3%
Year 2 Withdrawal: $40,000 + ($40,000 * 0.03) = $41,200
Repeat for subsequent years
By following this strategy, the goal is to balance enjoying your retirement while ensuring your savings last over the long term.
Keep in mind that personal circumstances vary, and it's a good idea to consult with a financial advisor/coach to create a retirement plan tailored to your specific goals, risk tolerance, and financial situation.