The 4% Rule

What is the 4% rule?

The 4% rule is a rule of thumb, first coined in 1994 by financial advisor Bill Bengen, which gives a retired (or financially independent) person a guideline for how much money they can withdraw from their accounts. The rule says this: A person can safely withdraw 4% of their investment portfolio each year, on average, and never run out of money.

Let’s break it down:

As savvy journeymen on the path to financial independence, we understand that a good investment is one that grows over time. The easiest, most dependable, and most passive type of investment is a low-fee index fund which follows the entire market.

Let’s assume that our entire portfolio is invested in a simple low-fee index fund that follows the total stock market, such as the Vanguard Total Stock Market Index fund (VTSAX) or the Schwab S&P 500 Index Fund (SWPPX). These are both great investments because they have very low fees and roughly follow the total US economy.

The average annual return for the entire stock market over the last 30 years is 9.89%. That’s huge! If you have $100,000 invested in an index fund that follows the total stock market, over the last 30 years you could expect that to grow by $10,000 per year without having to do anything! And if you have $1,000,000 invested, you could earn $100,000 without lifting a finger…a lot more than I could save working full time for an entire year as a physical therapist.

That doesn’t mean your portfolio will increase 10% every year. Some years will have even greater returns and others may even be negative.

But still, it pays to be a saver and it’s much easier to make money once you have money.

So if I follow the 4% rule, what happens?

Let’s say you follow the 4% rule for financial independence and withdraw 4% of your index fund portfolio every year. Meanwhile your portfolio, on average, is growing at 10% every year.

Congratulations! Your portfolio is passively growing more quickly (a lot more quickly…6% more) than you are withdrawing from it. You will never run out of money. In fact, you will gain money if your wealth increases by 10% and you only withdraw 4%.

Of course, life gets in the way. Uncle Sam will be around to collect his cut in taxes. You will have unexpected expenses. And almost certainly you will have to spend more on things like healthcare when you are 80 compared to 30. But the concept applies either way.

There is a level of conservatism built into the 4% rule for financial independence. Through simulation over the last several decades of stock market data, a person following the 4% rule would never run out of money with 96% certainty.

So a 4% withdrawal rate is not fool proof, but it is a very good rule of thumb.

How does this relate to financial independence?

I’m glad you ask! This is what we really care about.

If you are able to accumulate an amount of wealth that is great enough for you to live off of the 4% annual withdrawal, you have a 96% chance of never needing to earn another dime. You can live off your returns and you are financially independent.

Congratulations! Please spend your time pursuing something you are passionate about! (For me, I really hope to get involved in the scuba diving community again once I no longer need to work for money.)

How do I know when I’ve invested enough to reach financial independence?

You’ll need to know how much you spend every year. Which means you’ll need to track your expenses. When you know how much you spend every year, multiply it by 25 and you will find the amount you need invested to live off 4% of the portfolio returns every year.

For example:

Ignatius tracks his spending and knows he spends $35,000 every year.

He wants to reach financial independence so he can spend his time solving mysteries. He knows that his annual expenses are $35,000 and that this amount must be covered by his 4% annual withdrawal rate to never have to work again.

If 4% of his portfolio must be equal to $35,000, then

$35,000 / 0.04 = $875,000

or

$35,000 * 25 = $875,000

Ignatius needs $875,000 invested to safely withdraw $35,000 (4%) every year to never run out of money.

He better start selling hotdogs to accumulate that $875,000. But now he knows. And knowing is half the battle.