The 4% Rule - useful or useless?

Let’s take a closer look at the 4% Rule today.

What is the 4% Rule?

Some time ago, in America, before the 1990s to be more precise, financial experts believed that 5% was a safe amount of money to withdraw from your pension pot every year and not exhaust your savings.

The way you'd withdraw this 5% was this: you'd take out 5% from your pot in the first year and then you'd withdraw the same amount, adjusted for inflation, each year after.

How do we adjust for inflation - you might wonder. Here's how:

Let's say our pension pot is 500k in 2021. In the first year, 2021, we will withdraw 5%. So 500,000 x 0.05 = 25,000. Then the next year, 2022, we need to adjust that 25 000 by inflation of the previous year, so 2021. Let's say it was 3%.

So we have 25,000 x 1.03 = 25,750. And we continue with this approach, always considering the previous year's inflation rate. Which means we withdraw 4% only in the first year, then we withdraw the same amount as year 1, adjusted for inflation.

One man, William Bengen, who also happened to be a financial expert, started having doubts this would work. Doubts have this funny way of igniting curiosity. And so Bengen's curiosity made him conduct a study. He took historical returns - in other words, the results of the markets - and analysed them. He didn't look away from the toughest times - the 1930s and the early 1970s when the markets were least merciful and after all the huffing and puffing came to this conclusion: there was no case in which a 4% annual withdrawal exhausted a retirement pot in less than 33 years. In other words: 4% became the safe withdrawal rate of the day.

There is more to this study of course but this is the gist of it. As before, you're supposed to withdraw 4% in the first year, then the same amount adjusted for inflation each year after. Simple.

Who uses the 4% Rule?

As with any pension research, those keen on retiring early took the 4% Rule to their hearts and decided to put it to action. It became the basis of calculating one's BASTA number. They never called it that but don't you just love how the word "enough" sounds in Italian? So let's call it that. Here's how this calculation works:

First, you need to know your annual expenses after retiring. They're usually lower than your pre-retiring expenses. Let's say it's 25k. Then you flip the 4% Rule and figure out your 100%, your BASTA, the size of your Sesame, your pension fund. Here we go.

25k equals 4%, and we don't know how much equals 100%. We can do it this way or we take the 25k and divide it by 4%. Either way, we arrive at 625,000 pounds.

Aaaand this way, the 4% Rule gives life to the 25 Rule. It's a quicker way finding the same BASTA number. We take one year of expenses, multiply it by 25 and done! We get our big number again.

As you can see, it's a handy rule to know as it makes financial goals easier to set. It gives us something concrete we can measure our progress against and aim for. A bit like completing a marathon in a set number of hours.

But does it actually work?

Yes and no. Opinions are divided. Why? Because of when and how Bergen's study was conducted. And because a lot of pension research has been done since.

Generally speaking, there are two camps: those who say that the 4% is a very generous withdrawal rate and those who say that it's quite the opposite.

Why too high? The reasoning goes likes this... times have changed, asset performance has changed and if you're outside the US... well, the study didn't really consider that.

Why too low? Because the study focused on the bad bad times, the worst financial years so with the 4% Rule... you'll end up the richest man or woman in the graveyard. Your money will outlive you. Well., that's not fun!

So... The pessimist-realist camp say the number is closer to 3%. The optimists don't give a number.

For any investor, and especially one outside America, the 4% Rule presents some problems. Or challenges - if you wish.

So what are the problems with the 4% Rule?

The first one is taxes. That BASTA number we calculated earlier? It's gross income. So in 2021 for example, withdrawing 25k from our pension pot will give us 12.5k (12,570 to be exact but let's not be exact here) and the remaining amount will be taxed unless we withdraw it from a S&S ISA. If we never had an ISA, then oops, we need to adjust and re-calculate our BASTA number to cover taxes, too.

And while we're at money that quickly goes away - how about fees? It's great to plan and expect certain returns but fees will eat into those and so... reduce our returns. Reduced returns mean less money we can withdraw - back to square one, we need to re-calculate our BASTA number to include those too.

Next! What if we have the audacity to live much longer than 30 years? The 4% Rule states clearly that it will work for 30 years or so. But if we want to retire early and be lucky or unlucky enough, depends on your perspective on things, to live to say 95? William Bengen comes to the rescue! Most probably in small print, he added that a 3% withdrawal rate is the one that will make our pension pot last for 50 years. This is somehow rarely mentioned by anybody who's working on Financial Independence and retiring early.

Then there's no escaping the fact that the 4% Rule came out of historic data from America. Studies of markets in other developed countries produced different results.

Finally, the 4% Rule is credible, it was tried and tested. Many studies, including the famous Trinity Study, tested it and confirmed that YES, IT WORKS. But still, it isn't 100% safe. If you ever looked into food certification and what classifies as organic or free range for example, you will know that rules often have some funny tendency to become flexible. It's similar here but in terms of what classified as success and what as failure in those studies. What it means is that they cannot be taken as the truth and nothing but the truth I'm afraid.

How the 4% Rule shouldn't be used?

As our strategy or gospel. We cannot predict the future and if the markets plummet, so will our portfolios. At the end of the day it's a result of retirement research from 1990s America. There has been more research done since and we know that it works but it's not a 100% safe recipe for our Early Retirement.

How should we use the 4% Rule instead?

As a good introduction to investing and retirement. Guidance. If we want to rely on the 4% Rule only, for our safe withdrawal rate, we can use it as a benchmark but need to adjust it to accommodate: fees, taxes, length of retirement, asset allocation and so on. Oh, and whether we're planning to empty our pension pot or leave the capital to kids, friends or cats' charity. That matters too.

In short - it should be used wisely and, as much as we choose to use this rule, we should adapt as we go. Even Bengen, this year, said that considering the low inflation rates in America, the safe withdrawal rate is closer to... 5% again.

Do I use the 4% Rule?

Personally, both my small and large BASTA numbers are based on the 4% Rule. This is because in both cases I assume that I will continue working in some capacity for a number of years and I don't want to exhaust my savings. In other words, I want to preserve the capital. When we talk about taxes and investment fees - they are a part of a different problem. Mainly taxes from my employment and fees included in my expenses covered by that income. Say, I manage to make 12k per year, that pretty much covers my expenses apart from my mortgage. And these expenses already include the investment fees.

Striving for Financial Independence is a leap of faith - there's no doubt about that. It requires vision, strategy, discipline and a good dose of optimism. But it also relies on... luck. So time will tell what happens next but for now, as a rule of thumb - the 4% Rule and some good old-fashioned income generated by work... will do.

How about you? Will you base your BASTA number on the 4% Rule? Will you adjust it somehow? Feel free to let me know in the comments, I'm curious.