The 4% Rule

The 4% Rule is a popular guideline used in retirement planning to estimate a sustainable withdrawal rate from a portfolio. It suggests that a retiree can withdraw 4% of their initial portfolio value in their first year of retirement and then adjust that amount annually for inflation. The primary goal of this rule is to create a steady, inflation-protected stream of income that has a high probability of lasting for at least 30 years, without depleting the principal. For example, on a €1,000,000 portfolio, your first-year withdrawal would be €40,000. If inflation is 3% that year, your second-year withdrawal would be €41,200 (€40,000 x 1.03), regardless of whether your portfolio’s value went up or down. The rule provides a simple, powerful starting point for anyone trying to answer the million-dollar question: “How much can I safely spend in retirement?”

The beauty of the 4% Rule lies in its simplicity. It's a “set-and-forget” calculation for your initial withdrawal, with a straightforward annual adjustment. Let's walk through it with a clear example. Imagine you've worked hard and saved a retirement nest egg of €500,000.

1. Year 1: You apply the rule to your starting portfolio value.
   • €500,000 x 4% = €20,000
   • You withdraw €20,000 to live on for the first year.
2. Year 2: Let's say inflation for the past year was 2.5%. You don't recalculate 4% of your new portfolio balance. Instead, you adjust your previous year's withdrawal amount for inflation.
   • €20,000 x (1 + 0.025) = €20,500
   • You withdraw €20,500 for the second year. This ensures your purchasing power keeps pace with rising costs.

This process continues for the rest of your retirement. The underlying assumption is that your portfolio's investment returns will, on average, be high enough to cover both your inflation-adjusted withdrawals and preserve your capital over a 30-year horizon.

The 4% Rule isn't just a number plucked from thin air. It gained fame from a 1998 paper titled “Retirement Spending: Choosing a Sustainable Withdrawal Rate,” authored by three finance professors at Trinity University. This research, now famously known as the Trinity Study, looked at historical market data from 1926 to 1995. The professors back-tested various withdrawal rates against different portfolio allocations over rolling 30-year periods. The “success rate” was defined as the percentage of historical periods where a portfolio did not run out of money. What did they find? For a portfolio composed of 50% stocks (represented by the S&P 500) and 50% high-quality corporate bonds, a 4% initial withdrawal rate (adjusted for inflation annually) had a success rate of over 95%. In other words, in nearly all historical 30-year scenarios, the money lasted. This study provided the statistical backbone that turned the 4% guideline into a cornerstone of modern retirement planning.

While the 4% Rule is an excellent starting point, blindly following it in today's environment could be risky. A wise investor treats it as a useful reference, not an unbreakable law.

Several modern challenges cast a shadow on the original study's conclusions.

• Lower Expected Returns: The historical period studied by the Trinity team saw higher average interest rates and bond yields than we see today. With bond yields being low, the “safe” part of a portfolio generates less income, placing a heavier burden on stocks to deliver growth.
• Sequence of Returns Risk: This is the big one. The order in which you receive your returns matters immensely. Experiencing a severe market downturn in the first few years of retirement can be devastating. When you sell assets to fund your withdrawals from a portfolio that has just fallen in value, you have to sell more shares to get the same amount of cash. This permanently damages your portfolio's ability to recover and grow, a risk the 4% rule doesn't explicitly manage.
• Increased Longevity: People are living longer. The original study was based on a 30-year retirement. If you retire at 60 and live to be 95, you need your money to last 35 years or more, which reduces the “safe” withdrawal rate.

So, how should a value investor approach this? By applying principles of prudence, flexibility, and focusing on quality.

• A Guideline, Not a Dogma: The 4% Rule is a fantastic tool for initial planning to see if you are on track. However, it is not a “fire-and-forget” missile. Think of it as your baseline budget.
• Embrace Flexibility: Instead of rigidly taking the same inflation-adjusted amount every year, consider a dynamic approach. In years when the market is down significantly, perhaps you could tighten your belt and withdraw only 3% or 3.5%. In boom years, you might stick to the plan or even afford a small bonus withdrawal. This helps mitigate the sequence of returns risk.
• Build a Resilient Portfolio: A value investor's best defense is a well-constructed portfolio. Rather than just owning an index, focus on owning wonderful, cash-generative businesses with a durable economic moat that you bought with a margin of safety. A portfolio of high-quality dividend-paying stocks can provide a reliable and growing income stream that is less dependent on selling assets.
• Look Beyond the Portfolio: Your investment portfolio is just one piece of the puzzle. A complete retirement plan incorporates all sources of income, including state pensions, social security, and any rental or part-time work income. Integrating these reduces the withdrawal pressure on your portfolio.