William P. Bengen, an aeronautical engineer turned financial advisor, first talked about the 4 percent rule in a 1994 paper he published in the Journal of Financial Planning. That rule later turned into a widely used hack that many now use to guess their retirement number.
Though more a rule of thumb than a rule, it says that if you could live on 4 percent of your money starting with the first year in retirement and inflation-adjust that withdrawal rate from your investments each year after that, you’ll never run out of money.
But that was 1994 when Treasury bonds paid 8 percent interest. There was no way to fail unless you did something truly dumb.
The same Treasury bonds today yield 4 percent1. That matches the safe withdrawal rate just described but it does not account for inflation. You must hence do more than just buying Treasury bonds.
And that inflation-adjusted withdrawal rate needs to last the number of years matching your joint (you and your partner’s) life expectancy.
But say you still have 20 years to go before you’ll retire, and you know what your expenses are today. There are some big-ticket items in there like mortgage and college costs and then there are the little things like paying for food and travel.
So you don’t need to assume that your expenses from today will last forever. You need to think about your expenses 20 years from today when you’ll retire.
The two big spends – mortgage and college costs – would likely be done by then. What will remain are costs that are relatively tiny in the grand scheme of things and that is what you’ll want to plan for.
So, say those trinkets cost 80,000 dollars each year in today’s dollars. There will be expenses related to healthcare in retirement but you’ve planned for that by funding say an HSA.
So, 80,000 dollars is what you need today. Minus 30,000 dollars that you’ll get from Social Security and now you must plan for a net 50,000 dollars in expenses if you were to retire today.
But you’ll retire 20 years from today. Taking historical inflation rates into account, if you’ll spend 50,000 dollars today, you’ll spend 100,000 dollars 20 years from today to live the same or better life.
Which means you’d want to plan for 100,000 dollars in expenses the first year when you retire and inflation-adjust that amount for the remainder of your joint lives.
A 4 percent safe withdrawal rate hence means you’ll want to build to a portfolio value of 100,000 dollars divided by 4 percent = 2.5 million dollars. And you have 20 years to get to it.
But say you want to bulletproof your plan and leave a good deal of money behind for your heirs, you can assume a 3 percent safe withdrawal rate.
That means you will need to build up to a portfolio value of 100,000 dollars divided by 3 percent = 3.33 million dollars. That is a third higher than before but doable.
But if you want to die the richest person in the graveyard, you’ll use a 2 percent safe withdrawal rate. You’ll now plan for a portfolio value at retirement of 100,000 dollars divided by 2 percent = 5 million dollars. You’ll probably want to use a different portfolio structure than the usual balanced portfolios you will use for say the 4 percent withdrawal rate but now the problem statement changes to not just your life but equipping the next gen with the tools in managing the wealth they’ll inherit.
5 million dollars at retirement is a big number but again doable, especially for the ones reading this. And you have 20 years to get to it.
Thank you for your time.
Cover image credit – Julie Aagaard, Pexels
- March 31, 2024 ↩︎