Many retirement planners like to use the 4% rule when trying to determine the amount of your portfolio that you can safely withdraw in retirement. The main concept of this rule is that you can withdraw 4% of the money that is in your portfolio when you retire, every single year of your retirement. For instance, if you have $1 million invested when you retire, then you can safely withdraw 4% of this amount, or $40,000 per year. Not only can you withdraw it every year, but you can also increase the amount withdrawn for inflation, and your portfolio will continue to grow.
Of course, the 4% rule is not actually magic and a 4% return on your investments is not guaranteed. Instead, this rule is based on the Trinity study, which looks at historical data from 1926-2018. Since this rule only looks at historical data, it may not hold true in the future. In other words, 4% may be too high or too low of a percentage to withdraw because the future valuation of the stock market is unknown.
The Trinity Study
Completed in 1998 (and updated afterwards), the Trinity study sought to determine the safe withdrawal rate for a variety of stock and bond portfolios. The authors of the study looked at 30-year periods to see how often a portfolio made up of stocks and bonds would be able to provide a 4% withdrawal over these time periods.
Their findings were pretty overwhelming. They found that a portfolio which consists of 50% stocks and 50% bonds would have survived 95% of those 30 year periods. They also found that weighting the portfolio towards stocks improves the chances that the portfolio would survive.
The authors of the study also looked at different withdrawal rates besides 4%. Using lower withdrawal rates such as 3% shows that the portfolio has survived 100% of the time. Even higher withdrawal rates were okay historically, with the portfolio surviving 70% of the time for a 5% withdrawal rate and 51% of the time for a 6% withdrawal rate. However, withdrawal rates greater than 7% do not have very good survival rates.
How We are Impacted
For a future retiree, this study helps to determine the optimal amount of money to save for retirement. It also leads to the “multiply by 25 rule,” which shows that we can multiply the amount of money needed each year in retirement by 25 to determine the size of portfolio needed. For instance, if you think that you need $60,000 per year in retirement, then you may want to have a $1.5 million portfolio.
Of course, we haven’t included social security or other income in retirement, so our actual investment needs may be significantly lower. We may also be more conservative and use a 3% withdrawal rate or more aggressive by using a 5% withdrawal rate. Either way, this study shows us the amount of money that we can safely pull from our portfolios each year during retirement.
Looking at this, it is pretty easy to be discouraged! After all, it may be difficult to save up such a large amount of money before retirement. When things get discouraging for me, I usually try to see what I can do to improve the situation. Here’s some possible things to do:
- Save more money. This may seem like too easy of a solution, but saving more money is the quickest and easiest way to ensure that we have enough for our future retirement.
- Work during retirement. Especially for those of us that want to “retire” early, having a part-time job doing something that we love can be an easy way to supplement our retirement income.
- Base our withdrawal rate on how the stock market is doing. If the stock market is doing well, we may be able to increase our withdrawal rate. If the market is doing poorly, we may need to decrease our withdrawal rate.
- Realize that we may cut our retirement spending back as we near the later years of our retirement. As this article in the New York Times suggests, many retirees actually spend less money as they get older. Therefore, we may be able to spend 5% of our portfolio during the first decade of a typical retirement and then decrease this number as we get older.
- Supplement our portfolio with another “passive” investment. Perhaps buying a rental house or starting an online business will provide us with supplementary income when we are ready to leave our full-time jobs.
No matter how much money we have saved for retirement right now, we shouldn’t get discouraged by the 4% rule in the Trinity study. Instead, we should use it as a guideline to determine how much to save now for retirement and how much to withdraw later when we are in retirement. This study can also give us a good idea of what needs to change if we want to have a certain amount of money in retirement. Currently, I use this 4% rule to help me to determine how much passive income I will be able to rely on if I were to retire.
After thinking about the Trinity study, let us know in the comments what you may need to change about your retirement strategy. Will you need to save more money to retire when you originally wanted to? Or, do you already have enough money to retire now?
And thanks for reading!
~Nathan
Let’s keep living a great life … with the help of money. So what’s next?
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But no matter what you decide to do, let’s leave the ordinary behind and take action today!
