4% rule has been established as a golden rule over the last many decades but does it still work? If you have been looking for your magic number which would set you free from the daily routine of going to work to earn a paycheck, I am sure you have heard about the 4% withdrawal rule. Don’t worry I will lay it out for what it is and why you should and shouldn’t care about it.
Let’s start with what this rule is about
The 4 percent rule is a rule of thumb used to determine how much a retiree should withdraw from a retirement account each year. This rule seeks to provide a steady income stream to the retiree while also maintaining an account balance that keeps income flowing through retirement. Experts consider the 4 percent withdrawal rate safe, as the withdrawals will consist primarily of interest and dividends. – Source: Investopedia
Why does 4% rule not work?
There are a couple of pitfalls with this rule:
- In most cases, this rule assumes retirement life of 30 years which may have been true for earlier generations but Gen-Y and millennials are planning to retire early and they are healthier and will live longer than their parents as shown in the chart below
- 4% Rule ignores market volatility i.e. one big dip in markets or a recession can derail your entire plan. Keep in mind the big drop in the portfolio requires even bigger gains to just break even. Assume a $10,000 portfolio gets hit by 50% decline to $5,000. This portfolio will need a 100% gain to be back to $10,000 and it can take years to just recover from a step loss. I think it would be sheer stupidity to assume markets will continue to rise and ignore recessions from your financial planning.
What can you do, Instead?
So you understand 4% rule will probably not work if you are planning to retire early. The next obvious question – What can you do instead? Let’s walk through a bunch of scenarios that you can think about and choose from:
- Setup a target number that is high enough
- to sustain the worst market crash that you anticipate (in my case I assume 50%)
- Keep pace with inflation, to say the least, better can grow 2-3% above inflation
- Can support you forever (in case you live longer than average American). You don’t want to run out of money when you need it the most.
For this reason, I prefer to think of an perpetuity – it can support me forever. After me, my heirs can get a lump sum amount of money. If you don’t get the idea don’t worry, I will write a followup post on this topic and walk you through my personal calculations
- Setup a passive stream of income
- Semi-Retire: follow your dream or reduce working hours
- Accumulate a certain amount of money which can enable you to say no to your boss. I call it FU money
- Reduce your working hours, start freelancing or take the risk and follow your dreams.
- Say bye to your dream of Retire early. I don’t prefer this but sometimes, its the best option.
I am passionately working towards setting up multiple passive streams of income so I can retire early.
Share your thoughts in comments.!!