Have you ever wondered ‘How much money do I actually need to save to become financially independent?’ The answer, as it turns out, can be calculated using the 4% rule (or the ‘multiply by 25’ rule as it’s otherwise known).
The 4% rule (derived from the Trinity Study, 1998) is a rule of thumb which determines the safe withdrawal rate a portfolio can withstand without running out of money in a given time period. For example, a portfolio of £1 million could safely withdraw £40,000 annually.
The maths is simple but what can sometimes be more difficult is how to interpret this rule to help you work out exactly how much you should save to become financially independent. So let’s take a look at where this rule has come from, how you can use it in your own life (with examples) and any limitations.
What is the 4% rule?
The 4% rule has become a key concept within modern personal finance circles, however, we have to go back to 1998 to understand its origins. The Trinity Study (1998) was a paper published by the Trinity University, Texas which essentially aimed to determine a safe withdrawal rate (SWR) for future retirees. The SWR can be defined as the maximum rate at which you can withdraw money from your portfolio on a yearly basis without running out later down the line. For example, a 5% withdrawal rate on a £500,000 portfolio would mean £25,000 could be withdrawn annually (adjusted for inflation each year).
The study was conducted over 4 time periods – 10 years, 20 years, 25 years and 30 years on a variety of portfolio compositions i.e. differing percentages of bonds vs stocks.
The below table shows the results for a portfolio constructed of 100% stocks. The %’s within the table signify the proportion of the time the experiment was successful for each withdrawal rate (WR) i.e. in how many simulations the tested withdrawal rate resulted in the retiree not running out of money in the time period.
| WR | 15 years | 20 years | 25 years | 30 years |
| 3% | 100% | 100% | 100% | 100% |
| 4% | 100% | 100% | 100% | 95% |
| 5% | 100% | 88% | 87% | 85% |
| 6% | 91% | 75% | 70% | 68% |
| 7% | 79% | 63% | 59% | 59% |
| 8% | 70% | 53% | 46% | 41% |
| 9% | 63% | 43% | 35% | 34% |
| 10% | 55% | 33% | 30% | 34% |
The key takeaways from this data are that:
- At both 3% and 4% withdrawal rates, regardless of time period, you are almost guaranteed to not run out of money. This is where the 4% rule is taken from – as you can see above, 4% is the maximum withdrawal rate for which success is highly probable based on historical figures. Once you get to 5%, the proportion of successful simulations starts to fall rapidly.
- At higher withdrawal rates, such as 10%, the chances of failure (meaning to run out of money within your life time) are far greater. Over a 30 year retirement period, the chances of you withdrawing 10% of your portfolio a year and having any money left at the end of the time period is just 34%.
How the 4% rule can be used to help you achieve financial independence
So with the history out of the way, we can start to ask ourselves how this information can be useful in our shared journey towards financial independence.
Financial independence is defined slightly differently depending on who you ask, but for me, is is the point where you are confident that you have enough passive income (i.e. income you are not directly trading for your time) to cover your annual living costs. At this point, you are no longer dependent on a formal job and can begin spending your time as you choose rather than how your job dictates.
So let me ask you this – how much money would you need to have right now to be confident you can cover your expenses for the rest of your life?
Whenever I ask friends or family this question, the answers seem to vary wildly and arbitrary figures like £2 million or £5million start being thrown around. There’s 2 big problems with this; firstly, very few people will accumulate £5million of invested assets in their lifetime, this truly is an extraordinary level of wealth. Reverse engineering our formula from above, £5 million of invested assets would give us £200,000 (£5m*4%) to safely withdraw a year which represents an incredibly high quality of life.
Secondly, these random figures don’t take into account your current spending. If you currently only live on £50,000 a year, you don’t need £5 million invested, you need £1.25m (£50,000 * 25) which is a much more reasonable and plausible amount to save to.
Similar to any other goal, to achieve financial independence you have to be specific in what you are trying to achieve. The 4% rule allows us to assign a £ number to work towards. This is far more motivating than the generic goal of ‘becoming financially independent’. If you don’t believe me, consider this metaphor – which goal would you rather set yourself to maximise the chances of success in your goal to run a marathon. a) Run as often as I can and give my best on marathon day or b) Run at least 10 miles per week for the 6 months leading up to the race and ensure I have run 3 half-marathons and 1 full-marathon prior to race day.
As you may have worked out, I have never run a marathon (and don’t intend to any time soon!) but what this hopefully makes clear is that when it comes to setting an objective for yourself, being specific and measurable are the real keys to success.
An example of the 4% rule with real numbers
This rule of thumb isn’t intuitive to a lot of people, so let’s put some simple numbers up to demonstrate it.
Let’s say you currently work as a private school teacher and earn a gross salary of £45k a year. You are currently getting by with total expenses of £25k a year and living a modestly comfortable life style. You plan to retire in 10 years time and expect your annual expenses in retirement to rise to £30k a year in order to live a slightly higher quality of life with an extra weeks foreign holiday each year.
As shown below with reference to the 4% rule, you would need to save and invest £750,000 into a portfolio of stocks before you could comfortably retire.
- £30,000 / 0.04 = £750,000.
- £30,000 * 25 = £750,000
This suggests that if you were able to save up until you reached this £750,000 point and invest this money into a portfolio, you would be able to safely withdraw the £30,000 a year (adjusted for inflation each year) to cover your expenses for the rest of your life without worrying that your saved £750,000 would eventually run out.
Now for a lot of people, the next question may be ‘wouldn’t my money run out eventually if I stop saving?’
This is where the returns of the stock market come into play. Typically, a portfolio invested in company stocks may expect to grow anywhere between 5-12% per year depending on the specific investments in your portfolio. Taking the S&P500 for instance, which tracks the 500 largest Company’s in the US – between 1957 and 2018, your investment would return you 8% per year on average.
Applying this back to our example, let’s say you retire in the year 2030 with your target £750,000 safely tucked away in your portfolio, here’s what may happen in a good year (i’ve simplified the maths a bit for the sake of the example)
Opening: £750,000
Withdrawal on 1st day of the year: -£30,000
Remaining portfolio value: £720,000
Stock market returns for the year (8%): +£57,600
Ending: £750,000 – £30,000 + £57,600 = £777,600.
So, despite withdrawing a large chunk of money to pay our cost of living, the total balance has actually increased due to the returns our investments have given us. It’s worth remembering at this point that 8% is an average and for certain years, such as following the financial crash in 2008, the S&P500 fell 38.5% in a single year.
Now clearly a 38.5% decrease in your investment portfolio sounds like a detrimental problem for your financial life (and in some respects, it is) but the 4% rule has accounted for this eventuality and even in bad years such as 2008 – the 4% rule enables you to withdraw the same annual amount (£30,000 in our example above) with the statistical expectation that you won’t run out of money as the stock market fluctuations even out over time.
Although it’s not what the Trinity Study originally set out to do, the Financial Independence, Retire Early (FIRE) community has used the lessons learnt from the study to provide a simple to use tool to calculate your required savings pot in order to retire early. However, the Trinity study and subsequent use of the 4% rule is not without its criticisms which will be reviewed below.
Limitations and criticisms of the 4% rule
The main criticism of the 4% rule is that it uses historic data to project future outcomes. if you’ve ever bought a fund or company stock, you’ll have seen the disclaimer in big letters ‘Past performance is not an indicator of future performance’ on every page you click through too.
The trinity study was based on the period 1926 – 1995 which was one of the best performing periods for stocks in history. If the data we have used to determine a safe withdrawal rate of 4% is based on results from a high performing period, then the obvious concern is what happens if a retiree designs their entire retirement strategy around this rule but the stock market doesn’t align to the past performance.
Similarly, the data is based solely on the US Stock market. An investor here in the UK is unlikely to be invested in just US traded stocks which means this rule may need to be adapted for the local market. In David Sawyer’s excellent UK focused book ‘Reset’ – he lays out his justification for using a more conservative 3.5% safe withdrawal rate which builds in some wiggle room to account for these limitations.
As shown in the table above, the Trinity Study only reviewed time periods of up to 30 years. The average life expectancy here in the UK is 81 years old so this would mean retiring at 50. However, that life expectancy shoots up dramatically for well-off, healthy people as we would all hope to be (not to mention how many of us on the site would hope to retire before 50). This means that when we have a retirement period of over 30 years, we can place less reliance on this data.
Conclusion
The 4% rule was born out of the Trinity Study in 1998 which aimed to determine the safe withdrawal rate across a variety of time periods and portfolio compositions. The results of this study showed that based on historic returns, 4% is a safe withdrawal rate for a portfolio made up of only stocks.
The findings from this study have allowed the birth of the ‘4% rule’ within the Financial Independence, Retire Early (FIRE) community as a simplified tool to approximate the overall investment portfolio one would need to save to safely retire and live off of the passive income indefinitely.
While this serves as a helpful and motivational rule-of-thumb, the initial study and subsequent use of the rule has been subject to a number of criticisms including being based on a US centric, high performing period in history and being limited to a 30 year maximum time period.
This article has been written by Luke Girling, ACA – a qualified Accountant and personal finance enthusiast in the UK. Please visit my ‘About‘ page for more information. To get in touch with questions or ideas for future posts, please comment below or contact me here.