FIRE Pillar 10: Practice The 4% Rule
If you want to gain financial independence and retire early, it is important to invest in assets that will passively produce income for your retirement years. Many FIRE Movement disciples practice the 4% rule help to achieve this.
In this article, we explain what the 4% rule is, why it’s used and how it works for early retirement.
What is the 4 percent rule?
According to Investopedia, the 4% rule came about as a result of a study by the financial advisor, William Bengen, in the mid-1990s.
The rule is used to work out how much of a stock portfolio can used as spending money i.e. withdrawn, on an annual basis, without the money ever running out. This is known as your ‘withdrawal rate’.
For example, imagine you had £100,000 when you retired. According to the 4% rule, you could take £4,000 from your portfolio in your first year of retirement.
According to this framework, you should have enough money invested in assets cover your spending money for a year If you do not withdraw more than 4%.
Why adopt the 4 percent rule?
The 4% rule works on the basis that the average annual growth of your stock portfolio is 7%. As the average inflation rate is 3%, in theory you should be able to use 4% of the investment growth for your current/ future expenses. This means, you should have sufficient income from your investments for living expenses until you die.
4% rule for early retirement
The rule works on the basis that retirement will last 30 years.
If you succeed in all of your FIRE goals and retire early, you could stop work as early as your 30s or 40s. Obviously (or hopefully) your portfolio would need to last a lot longer than 30 years, possibly even up to around 60 years.
So how would this framework stack up if you were to retire before the traditional retirement age?
The 4 percent rule works on the assumption that you would be completely retiring and never again adding to your portfolio.
For those working towards financial independence, this is not necessarily the case. While FIRE advocates want to retire from the 9-5, many will go on to earn money in other ways, on their terms.
Very few people will be aiming to just sit on a beach and sip cocktails for the next 60 years of their life. The FIRE Movement is about freedom to do what you love, rather than be trapped in a career or job that you hate. To earn more money, many people will still take on different projects or earn money from other sources (property rentals, for example), throughout retirement.
Whilst the 4% rule assumes that you will always take the full 4% from your portfolio, this may not be the case, as you may not need the full amount (especially if you have other earnings). This means you can leave more in your investment portfolio for growth.
However, it is important to note that the 4% rule is not without its critics.
For example, if there is a market dip when you retire, you could struggle in the future. This is one of the biggest risks and is known as the ‘early sequence of returns’.
Also, if your portfolio contains any higher-risk investments, withdrawing 4% may not be advisable, especially early on in retirement.
Summary: 4% rule for FIRE
When it comes to money, nothing is ever 100% certain.
However, as a rule of thumb, the 4% framework seems to work well for those aiming to retire early, especially if income will be supplemented in some other way.
The chance of your portfolio succeeding in supporting you through retirement could be increased by taking on a side hustle or renting out properties, for example.
The 4% rule works best as a general guideline, rather than a hard and fast rule. It’s important to make a retirement plan based on your circumstances, ideally with help from a financial advisor. However, when you are planning your early retirement, the 4% rule is a useful starting point.