What is the 4% rule?
The 4% rule is the math that underlies the entire concept of F.I. (financial independence) and having the option to R.E. (retire early). According to the research in the influential Trinity Study, you can safely withdrawal 4% of your invested portfolio every year and still have just as much (or more) left over than where you started (inflation is calculated in this number). Viewed in the opposite direction, you need to save and invest 25x your expenses to be able to live purely on the growth in your portfolio for the REST OF YOUR LIFE. The logic goes that the market will return on average 7% minus 3% for inflation, leaving enough for you to safely withdraw 4% year after year after year.
For example, if your retirement expenses are $40,000 / year, you would need $1,000,000 (40k x 25) in invested assets to generate enough returns to live off indefinitely. Drop your expenses to $30,000 / year, and you would only need $750,000. On the flip side, if you spend $100,000 / year, you would need $2,500,000.
Why it matters
It’s really hard to get somewhere if you don’t know where you’re going. Goals such as “I’d like to retire early” are too vague. The 4% rule gives you a concrete target to aim for, and helps put into perspective where you’re at in your journey towards financial independence.
I had always been frugal (thanks Dad) and always knew even in my late teens and early twenties that I would loathe a 40+ year career stuck a desk. I maxed out my 401k every year and saved a large % of my income from very early on in my career, but didn’t necessarily see a concrete path to financial freedom.
When I discovered the 4% rule, from the likes of Mr. Money Mustache and the Mad Fientist, it was a profound experience. Although I was well on my path, I discovered the math behind the 4% rule at 26 and it gave the motivation to supercharge my saving, slash my expenses, and pump as many dollars into my investments as I possibly could. It made me realize this fuzzy idea was real and actually achievable. I wouldn’t have to wait until I was 65 to retire…wow.
What I love about the 4% rule is how simple it is. That is undoubtedly why it has caught on within personal finance circles. 25x your expenses.
What the 4% rule also implies is that your journey towards financial independence can be shortened one of two ways. Increase your earnings or decrease your expenses.
Decreasing expenses is easier
Although there are lots of things you can do to increase your income, they are hard. Changing jobs, earning a promotion, negotiating raises, expanding your skills, closing more deals for you sales folks out there. I am in no way discounting the importance of getting really good at something and selling your skills to an employer or to your own customers for as much money as you possibly can. However, these things are more long-term. You can’t just decide to get a raise or get a promotion.
On the flip side, you can decrease your expenses IMMEDIATELY. Right now. Some things may take longer, such as moving to a cheaper neighborhood or selling your car. However, to do these things doesn’t require anybody else’s approval (other than your significant other potentially). You can eat out less starting right now, cancel your gym membership (or god forbid, sell your Peloton) and work out at home, cancel your cable bill, and so on. You can take these actions right away to reduce your expenses and significantly shorten your runway to financial freedom.
The 4% rule is not the whole picture
Retirement isn’t the end of work
What the 4% rule does not take into account, especially for folks chasing early retirement, is that retiring doesn’t mean the end of work. It means the end of working because you HAVE TO. Assuming you are the type of person with the work ethic and self-discipline to pull off something like early retirement, you are highly employable. You likely possess skills that the market values quite highly. And you are likely an intelligent, curious person that has hobbies or projects they’d like to pursue with all of the extra free time you now have in early retirement. Without a doubt some of these hobbies or projects will lead to opportunities to earn money.
I see a lot of individuals in the finance community that have reached their financial independence goals, but don’t pull the trigger and actually leave their jobs out of fear. They are worried they will run out of money one day. “Okay, let me just work one more year and then I’ll be comfortable”. If you love your job, great, no reason to stop. However, if you’re chasing financial independence to get out of the rat race and focus on work you enjoy, trust that you will make money in that process somewhere along the way.
For example, let’s say you were able to get your expenses down to $30,000 / year, making your “F.I. number” $750,000 (30k x 25). If you could earn $10,000 after tax by working part-time, real estate, a side hustle, etc, you technically only need to make up the $20,000 difference in expenses to be financially independent. So now your F.I. number is only $500,000.
“Retirement” does not mean the end of work. Although it can be hard to plan for, don’t discount your (or your spouse’s) future earnings in your calculations. I could always get another sales job if I really needed to.
What the 4% rule also fails to account for is social security and Medicare kicking in eventually. Eventually your health care expenses will go down significantly and you will have an additional income stream in social security that is not being accounted for when you retire early.
So that’s the 4% rule. 25x your expenses invested and you made it. You can retire. Or you might be there already if you want to change careers or work part time.
What do you think?
Leave any questions or feedback you have in the comments, I’d love to hear from you!