AndreyPopov/iStockPhoto / Getty Images
My husband and I started working in 2006, invested enough to retire in 2015, and have been living the financial independence retire early (FIRE) life for the past decade.
We calculated that we needed a $1-million portfolio to support our $40,000 annual living expenses, using the 4-per-cent rule.
This rule of retirement stipulates that you can safely withdraw 4 per cent of your portfolio each year without ever depleting it. That’s why you multiply your targeted yearly living expenses by 25 to calculate the amount you need to have invested to generate that income.
A lot has changed since we left our 9-to-5 jobs: We visited 50 countries, tripled our net worth and had a kid. And now, given that our family relies on the 4-per-cent rule for our day-to-day expenses, it’s imperative that this mathematical calculation still holds.
They planned to retire early. Rising costs are putting that to the test
I was shocked – pleasantly – to discover recently that it no longer applies.
One of the biggest criticisms of the FIRE movement is that the 4-per-cent rule is too high and should be revised down to 3 per cent.
To understand the 4-per-cent rule, we need to go back to the 1994, when a financial planner/MIT aerospace engineer named Bill Bengen devised it. He wanted to discover the withdrawal rate that would survive the worst retirement sequence in modern history.
He called this the maximum safe withdrawal rate (SAFEMAX) and using a portfolio of roughly 60-per-cent stocks and 40-per-cent fixed income, adjusting annually for inflation, and a 30-year retirement period time frame, he deduced that 4.15 per cent is the amount you can safely withdraw to withstand the worst possible scenario. This got rounded down to 4 per cent and became the “4-per-cent rule.”
He has since released a book called A Richer Retirement, where he ran the simulation again to test the plan against the most recent market history. He discovered that the most recent worst case year is 1968 – a year with a scary combination of a bear market and high inflation. The SAFEMAX for this retiree was found to be 4.7 per cent, when compared with retiring in any other year so far.
This means the rate of his 4-per-cent rule can safely be adjusted to 4.7 per cent.
I’m two years from retirement and my portfolio is down. How can I recover?
Keep in mind that this is the worst-case scenario, not an average. This would be like driving to work every day and hitting every single red light, every single traffic accident, and bad weather. In other words, 4.7 per cent is a conservative figure.
One of the most surprising ideas in the book is that retirees often underspend. Mr. Bengen showed that you will have a significant amount left over if you withdraw less than inflation each year.
In my experience in the FIRE community, this is what happens for early retirees because it’s much easier to beat inflation if you no longer need to drive to work, eat out frequently because you’re pressed for time, or live in an expensive city for work.
Also, this analysis ignores human behaviour. When markets fall, people naturally tighten their belts. When inflation is running rampant, early retirees get creative about what they eat, how they entertain themselves, etc.
So when you spend less than inflation, you end up with a substantial portfolio at the end of life. Mr. Bengen argues that contrary to popular belief, it’s more likely for retirees to end up dying with far more money than needed.
Analysis: We have two retirement ages: the one Canada set and the one Canadians use
Another fascinating observation is that inflation may be more harmful to finances than recessions. That’s because markets eventually recover, but prices driven higher by inflation don’t fall.
Mr. Bengen uses the analogy of a balloon with two holes. One hole is recessions. The other is inflation. Both are causing air to escape. Both hurt you because one crushes your overall net worth, and the other causes forces you to withdraw more than you planned.
When both happen at the same time – as it did in 1968, the worst year to retire – you need a required SAFEMAX of 4.7 per cent.
One tool to fight inflation that Mr. Bengen didn’t mention is sometimes referred to as geographic arbitrage – changing where you live to take advantage of cheaper living costs. That’s something you can leverage in retirement because you no longer need to live in expensive cities – or countries – for work.
So, to all the critics who said the 4-per-cent rule is dead – you’re right. Long live the 4.7-per-cent rule.
Kristy Shen and Bryce Leung retired in their 30s and are authors of the bestselling book Quit Like a Millionaire.
