The Magic Number for Retirement
Is 3% the new 4%?
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Before we jump in, let’s do this quick thought experiment.
An American investment banker was taking a much-needed vacation in a small coastal Mexican village when a small boat with just one fisherman docked. The boat had several large, fresh fish in it.
The investment banker was impressed by the quality of the fish and asked the Mexican how long it took to catch them. The Mexican replied, “Only a little while.” The banker then asked why he didn’t stay out longer and catch more fish?
The Mexican fisherman replied he had enough to support his family’s immediate needs.
The American then asked, “But what do you do with the rest of your time?”
The Mexican fisherman replied, “I sleep late, fish a little, play with my children, take siesta with my wife, stroll into the village each evening where I sip wine and play guitar with my amigos: I have a full and busy life, señor.”
The investment banker scoffed, “I am an Ivy League MBA, and I could help you. You could spend more time fishing and with the proceeds buy a bigger boat, and with the proceeds from the bigger boat, you could buy several boats until eventually, you would have a whole fleet of fishing boats. Instead of selling your catch to the middleman you could sell directly to the processor, eventually opening your own cannery. You could control the product, processing, and distribution.”
Then he added, “Of course, you would need to leave this small coastal fishing village and move to Mexico City where you would run your growing enterprise.”
The Mexican fisherman asked, “But señor, how long will this all take?”
To which the American replied, “15–20 years.”
“But what then?” asked the Mexican.
The American laughed and said, “That’s the best part. When the time is right you would announce an IPO and sell your company stock to the public and become very rich. You could make millions.”
“Millions, señor? Then what?”
To which the investment banker replied, “Then you would retire. You could move to a small coastal fishing village where you would sleep late, fish a little, play with your kids, take a siesta with your wife, stroll to the village in the evenings where you could sip wine and play your guitar with your amigos.”
This is one of my favorite stories. It highlights the skewed priorities and massive miscalculation people make on the amount they need to retire comfortably. I preach frugality on my channel because the usual tendency is to spend more than necessary. But the other side of the coin could be equally damaging – If you hoard a fortune but never spend any of it, what’s the point? What we need is a balanced approach. Fortunately for us, William Bengen created the 4% rule way back in 1994 as a rule of thumb for the amount you can spend every year without running out of money.
The strategy is simple: Once retirement starts, you can spend 4% of your portfolio every single year without running out of money. For example, if you have a million-dollar portfolio now, you can effectively spend $40K every year, on whatever you like. This is because your portfolio grows by an average of 7.5% every year adjusted for inflation – you could safely spend half of that while leaving the rest to continue working on your behalf, so that you’ll have more to pull from in the next year.
But, before jumping into this, you need to be aware of the two common pitfalls
Spending too much: You need to make sure that you are not spending too much in the event that your investments don’t grow at the expected 7.5% rate.
Spending too little: At the same time, you don’t want to spend too little to the point where you could have spent more money and lived more comfortably but didn’t because you were afraid of running out of money.
To avoid both of these, researchers simulated every single retirement year in history and then projected how much would have been left assuming the worst-case scenario. This is how the 4% rule was born.
If you had a 75-25 portfolio made of stocks and bonds, you’d have a 99% chance of not running out of money during a typical 30-year retirement according to the 4% rule. This would hold even if we see a market drop as we did in 2022 or, runaway inflation as we did throughout the 1970s or even the Great Depression of 2008.
Issues with the 4% rule
Despite the success of this rule, other experts are now beginning to argue that the 4% rule is too simplistic and could actually leave you completely broke if you are not careful.
Ben Felix (I highly recommend checking out his YouTube channel) argues that the 4% rule was based on a 30-year retirement. If you plan to retire early (as most millennials are doing) or end up living considerably longer than average, you have a real chance of running out of money.
In addition to this, the entire portfolio was based on the performance of U.S. Stocks and Bonds which have seen some of the strongest returns throughout the entire world! We might have just got lucky living in one of the best possible time periods for stocks. According to the equity premium puzzle, stock investors are rewarded for the risk that they take on. But over the last few decades, the reward has been much higher than the risk, and their luck could run out.
Another possibility is that the U.S. could simply be the ultimate example of survivorship bias. The high stock market returns we are experiencing could be the exception - not the norm.
The final argument against the 4% rule is that once you look beyond the U.S., most of the developed countries have returns that are nowhere close to the annual 7-10% that we are used to here in the U.S.
Retiring Young
I have been an avid follower of what’s called The Financial Independence Retire Early (FIRE) community, where the entire goal is to track your expenses, optimize your investments, and grow a portfolio to the point of sustaining your lifestyle as long as you live. Recent research from Vanguard found that 1 out of 3 millennials plan to retire before they are 60. This is where the withdrawal rates become important. If you retire at 60, you are expected to live for another 25 years. But, if you retire at 40, you need to sustain yourself for the next 45 years!
Ben argues that to follow FIRE, a 2.7% withdrawal rate is going to be the safest option. This gives the retiree the highest chance of living a long life without running out of money. The catch is that you need to save more before retiring because your monthly expenses would be the same. If you needed $1 million to retire at a 4% withdrawal rate, you would need $1.48 million at a 2.7% withdrawal rate.
Even the creator of the 4% rule, William Bengen has come on record to say
The current market conditions may require an even more conservative approach, and the combination of 8.5% inflation with high stock and bond market valuations makes it difficult to forecast whether the standard playbook will work for recent retirees.
What should you do?
Given the multitude of opinions in the market, I have simplified it into a 3-step process that anyone can follow.
Spend Less: I know it sounds obvious, but if you want to retire longer, adjust your spending accordingly. If you want to retire for more than 30 years, you will likely need to reduce your spending to 3% – For some people, this might mean spending the 2.7% as recommended by Ben Felix or 3.5% if you want to retire “only” for 35 years - pick your poison!
Practice variable spending: This simply means that when the times are good you spend more but when your investments are down, you spend less. This way you have wiggle room on everything that isn’t 100% necessary.
Diversify into international markets: Through the last 50 years, international stocks have actually outperformed the U.S. market on several occasions. Vanguard also believes that using a mixed portfolio could increase the chance that your money lasts longer by more than 20%!
By adding international diversification to the portfolio, the withdrawal rate can increase from 2.6% to 2.8%. By reducing fees from 100 bps to 20 bps, the rate can rise further to 3.3%. Finally, by using a dynamic spending rule, the rate can rise to 4.0%. - Vanguard Research
Personally, I think the 4% rule is really great because it forces you to think about how much money you can spend. Let’s be real – most people have no idea how much their lifestyle costs. But by calculating how much money you can spend, you will be able to work backward to determine how much you will need to retire.
In addition to that, it also helps you separate how much you need to have versus, how much you want to have. For example, your mortgage payment might be non-negotiable but, your Mercedes could very easily be replaced with a Toyota costing a third of the price if something were to happen.
That’s why I personally follow the 3% rule, knowing that I can easily cut back when needed but I can also “plan for the worst,” without over-extending myself in the event I live to 120 and still want to play around with Reef Aquariums, which happens to be a very expensive hobby.
Now, go back to what you answered on the poll and apply the 3% rule - does it still make sense? Do you really need that much? Or did you underestimate what’s required to retire? Let me know in the comments.
Stay safe, stay invested and I will see you next week – Graham Stephan.
A lot of effort and research went into making this article, so if you found it insightful, please help me out by clicking the like button and sharing this article.
Graham - (1) How do you see this rule changing if you receive a higher RoR through Real Estate? (2) The missing piece for me is how to best withdraw money once retired, to avoid taxes and fees? I would love an article on this topic as you always do thorough research. It would also help us readers pre-plan our investing if there are withdrawal benefits in different areas of investments. Thanks!
I like that you and Ben Felix are connected!