Just in case you were wondering, yes I type in Spanish (because Goggle Translate showed me how). What does that beautiful Spanish sentence above mean? Of course it means Sexy Finance Notes. You are welcome. Notas de finanzas Sexys. Make sure you try to say it like three times in an Antonio Banderas’ accent, preferably to your spouse or significant other.

In this series (the Notas de finanzas sexys series) we discuss other important aspects you need to mentally grasp to make sure you are truly making large jumps in your financial goals. See, the sexy series title makes all the sense now, right? With this particular post, we are going to deep dive into the 4% Rule, which helps you understand how much money you need to be completely financially independent (and retire early if you so wish).

This topic is somewhat cool to discuss in this post because this year (2024) is the 30th anniversary of the topic at-hand (the 4% rule). Back in 1994, a very smart gentleman named Bill (William) Bengen had the great idea to try to study the historical returns of a 50/50 portfolio of bonds and stocks, represented by US large company stocks and US Intermediate-term Treasury bonds, in order to find out the best withdrawal rate to use for someone to safely maximize their retirement income. Since 1994, Mr. Bengen has adjusted his allocations to further study the information and improve his findings.

Let’s take a step back, though. What is a “withdrawal rate”? A withdrawal rate is the dollar amount you withdraw from your investment portfolio every year for income, based on a percentage of your investment balances. For instance, if you had a portfolio of bonds and stocks (or one or the other) that equaled $500,000, and you had a withdrawal rate of 5% a year, you would withdraw $25,000 that first year (5% of $500,000 = $25,000) for income. So, in this instance, your withdrawal rate would be 5%. Buzz kill alert, that may or may not be a good withdraw rate for you. More on this later.

What Mr. Bengen was trying to find out (and did), was what a “Safe Withdrawal Rate” would be. He called this the “SAFEMAX”. This means that he was looking for a worst case percentage that someone could take out every year, based on that portfolio design, and never run out of money over 30 years of withdrawals. Or, in other words, what percentage of your assets could you take out each year so you could likely live without the worry of running out of money during retirement. If someone takes out too much money every year, they will be guaranteed to run out of money. Obviously, that is not a good situation. But if they take out too little money every year, they may not live the comfortable life they could. Hence why the study was completed, to give people mathematical safe rates of withdrawal to maximize their income while keeping their investments and income safe.

Bengen’s original study led to the findings being called the “4% Rule”. A quick note before we jump into detail on the 4% Rule. To start, the 4% Rule was not what Mr. Bengen named his findings. Other people simplified his information and called it the 4% Rule for strategic and easy discussion points. Also, it is good to know that his findings are at no point a “Rule”. Rules should not be broken, traditionally. Mr. Bengen’s findings are only meant to be a rule-of-thumb and can be altered to each person’s specific scenario. Who would have thunk that other people would morph the actual information into something of their own making instead of just following the actual data? That never happens, right?

What the original study actually showed was that the worst/lowest withdrawal rate that would be needed to make sure someone had enough money in their investments to last 30 years, was a withdrawal rate of 4.2% (rounded). This looked at all years, and their subsequent 30 years of returns. The years, due to the length of time, therefore covered years of high inflation, market crashes, wars, depressions and more. Even though all of those historical events caused major issues to the investments people had, the 4.2% withdrawal rate still lasted the 30 years needed.

The 4.2% withdrawal rate, apparently, doesn’t sound as cool as the 4% withdrawal rate, and the average was rounded down and spread throughout the financial communities as “the 4% Rule”.

How is this information used by you (and others) in your investment and retirement planning? In two ways:

1. When you begin taking out income for yourself from your retirement accounts, you know that you could liquidate and take out at least 4% of the funds each year without major worry for your portfolio’s health. And, in fact, you could take out a little higher percentages than the 4% and likely still be just fine.
2. You can reverse the calculation in order to also figure out the worst case amount of assets you would need to save up in your investments to cover your retirement (without even including social security). For instance:
   • If you have an investment portfolio of $1,250,000, and you withdraw assets based on the 4% Rule (we will use exactly 4% in this calculation to keep it simple) you could take out $50,000 a year and you would be even safer than you would need to be on your withdrawal rate. If we flip that, and you find out your expenses that you need to cover in retirement equals $50,000 a year, you could multiply those yearly expenses ($50,000) by 25 and that would be all the money you would need to safely retire (if you kept your expenses at $50,000 a year, plus inflation). $50,000 x 25 = $1,250,000 (the same balance as above).

What if you wanted to be a little more aggressive with your withdrawal rate? Say you needed a little more income in the beginning or you wanted to retire a little faster and not save up so much in your investments. Well, that has been studied as well.

Let’s say you instead opted for a 5% withdrawal rate. On a $1,250,000 portfolio, you could then take out $62,500 your first year instead of the $50,000 (with the 4% withdrawal rate). So you could live a little more high on the hog, as they say.

Or lets say you still only needed $50,000 a year for income from your investments, but you wanted to use a 5% withdrawal rate instead of a 4% withdrawal rate. You would then just multiply the $50,000 of income you needed by 20 (instead of 25), which would show you that you only needed $1,000,000 in investment assets and could save $250,000 less than you had originally planned (with the 4% Rule). So, you could likely retire much, much faster, by having to save $250,000 less for retirement.

The question, of course, then comes up regarding how much extra risk does that add to your retirement, if you took out 5% a year compared to 4% a year? Or if you took out other percentages, how much does that change the likelihood that you would not run out of money?

For the answers to that, we need to switch over to what is called the “Trinity Study” which was included in the February 1998 issue of the Journal of the American Association of Individual Investors¹. The Trinity Study, though using different types of investment indexes in their study than what Mr. Bengen used, created a chart to help with understanding the likelihood of running out of money during retirement. They did studies on different types of portfolio designs (so having all stocks/equities as investments compared to having 50% stocks and 50% bonds), on different ranges of withdrawal rates, and over different periods of time.

With their chart, we can take a more detailed understanding of the different levels of risk. Here is the chart below. I highlighted the 4% withdrawal rate over 30 years and the 5% withdrawal rate over 30 years for you to see.

As shown in the chart, the studies found that if you had a 50/50 stock and bond portfolio, and you withdrew 4% of the portfolio every year, you would have a 100% chance of not running out of money over a 30 year period of time. Pretty cool, aye? If you instead switched it to a 5% withdrawal rate, your likelihood of not running out of money (with that same portfolio) would drop down to a 70% chance.

70% chance of success is still pretty high. So you could feel moderately comfortable taking out that percentage with your retirement time frames at 30 years. But it is also 30% less likely that you would not run out of money in comparison to the 4% withdrawal rate. A 30% drop is fairly large, in comparison.

What is the right answer? That is up to you. Are you comfortable with that added risk? If so, use the 5% withdrawal rate and just be a little extra diligent with monitoring your investments and withdrawals to protect yourself and your future. If you are not comfortable with that much added risk, you could try a couple other options:

1. You could use the chart to change your allocation to 75% stocks and 25% bonds, which bumps up your percentage likelihood another 8% over that same 30 year period (with 5% withdrawal rate).
2. You could drop down to 4.5% withdrawal rate. Though we do not know what 4.5% withdrawal rate shows for risk, we can estimate it would be around the middle risk percentage of 4% and 5%. So, at the 50/50 portfolio, you would have approximately 85% likelihood of not running out of money.
3. Or you could combine these options. Maybe you switch to a 75/25 portfolio and use 4.5% withdrawal rate. If we take the middle percentage between 4% and 5% of the 75/25 portfolio, that would mean you would have a potential likelihood of not running out of money over 30 years around 88%.
4. And of course, you could just stick to 4% that the trinity study shows above, or opt for the 4.2% from Mr. Bengen’s original study.

Either way you go, you now understand your risk and the calculations to understand the amount of money you need to retire. Take this and use it to reach your goals as fast as you can.

Now that you know how to spend in retirement, and how much you should save for retirement, let’s talk about how to get there. Though there are a good number of posts you could go to for next steps, lets start with simple ones.

1. https://www.aaii.com/journal ↩︎

Why not finish with something random and completely unrelated to this conversation, you ask? Yeah we can do that. Here is a cool picture from space for you to make your eye balls smile.