What's the 4% Rule?
Today, we are talking about one of the most important financial concepts to know: the 4% Rule.
Years ago, when I was going through my debt free journey, I found myself googling resources figuring out how to save as much money as possible. I wanted to ace the debt freedom journey and get rid of my debt as soon as I could.
During the course of my research, I came across a blogger named Mr. Money Mustache. Pete Adeny, the blogger who runs the Mr. Money Mustache website, is someone who retired at age 30. And he's nearing 50 now. So he's been retired for a couple of decades.
At the time that I was reading his blog, I was really interested in some of his savings tips. Now if I were to describe Pete as a saver, I would call him a super extreme saver. He and his wife and their child were living on a household budget of $25,000 a year.
Meanwhile, they were earning an excess of six figures total. So they were saving over 70% of their income!
I found myself wondering why anyone would be crazy enough to do that. It definitely seemed like a big sacrifice.I was happy to take some of their savings tips and apply them to my own life, but it made me wonder…why would you make so much money and spend so little of it?
The FIRE Movement
What I learned was that he and his wife were following the FIRE movement. “FIRE” stands for “financial independence, retire early,” and there are thousands of people all around the world– probably millions–following this plan so that they have the option to retire at any age.
And there are many people who follow Pete's path and retired at the tender age of 30 or earlier.
The question is, aside from extreme saving, how were they able to retire without being worried that they were going to run out of money?
What I came across was a very simple calculation that people in the FIRE movement use to calculate their assets. This calculation is called the 4% Rule. Now before we get into how it works, I want to tell you where it came from.
The Trinity Study
Once upon a time, there was a group of economists who got together to study the market and understand different retirement account scenarios. They looked at different types of holdings, different allocations, and 30 year periods in the market, to understand how much money one would have to have invested for their money to last.
This study has come to be known as the Trinity study. (You can google it and read all of the juicy details even today.)
They weren't interested in early retirement when they conducted the study. They were simply running financial models of the market. Here are some things we know about the market that factored into their scenarios. If you look at any 30-year period in the history of the stock market–including the Great Depression, including the recession of 2008, looking at the history of the market including all of the dramatic ups and downs–you will find that in any 30-year period, the stock market has generally returned around 7%.
So if you had your money in the market at any point in its history, over a period of 30 years, you would make 7% on that money.
That's a really interesting number to know because it helps us understand that if we invest in the stock market today, over a long time period horizon, we might expect to make at least 7% on our money. I say at least 7% because over the past 100 years that average has been inching up to around 10%.
(And of course, over the past few years that number has been exponentially higher, but we don't need to worry about that because we're thinking about long-term horizons.)
The 4% Rule Emerges
So let's use 7% because it's the safest conservative number for us to use. Now, people who follow FIRE looked at this study and extrapolated the answer to their question, which is how much money would I need to invest to be able to retire and live off of my retirement funds forever. Not just for the next 30 years, but indefinitely, and be able to pass that money along to my heirs in the form of generational wealth.
This is where the concept of the 4% Rule emerges. The 4% Rule is essentially this: if you have your money invested in a portfolio that mirrors the total stock market, then you can safely withdraw 4% of your money each year and the remaining amount will continue to grow at the rate of inflation (that means that even if you withdraw 4% of your money every year, the amount in your account will never decrease and you'll be able to continue to withdraw 4% every single year for ever). Definitely pretty cool, right?
If you're wanting a simple way to understand how that calculation works, here's how I like to think about it. Remember that 7% number that we talked about–that the market generally returns a rate of 7% over any lengthy period?
Well, imagine that your portfolio has grown by 7%. And let's take inflation into account. What is inflation? It's when the cost of goods goes up and how much you can buy with the same amount of money goes down. Inflation is a really important concept to know because if you don't invest your money over time, your money is actually losing value.
So that money that you've got stashed under the mattress or sitting in a savings account is actually becoming worth less and less year after year due to inflation. This is really important to keep in mind.
The inflation rate in the US over time has averaged around 3%. Sometimes it's higher, sometimes it's lower, but 3% is a good average to keep in mind.
Calculating Your Retirement Number
So let's put those numbers together. If you have a portfolio that has grown by 7% and you subtract the 3% inflation rate, 4% is what you have left over. Four percent is the amount of those earnings you could take out while the remaining amount in your account continues to grow at the rate of inflation, which means it doesn't lose its value. As the cost of goods goes up, the amount of money in your account goes up to match.
If you are super mathy and you care a lot about the numbers, you'll note that on an annual basis these numbers fluctuate quite a bit. It may be helpful for you to go back and read the Trinity Study to understand all of the scenarios more closely.
If you're the average person who wants a shortcut, the 4% Rule is your guide to how much money you'll need to have invested and how much you can take out each year so that you can live on those investments for the rest of your life.
So, now you might be wondering how do I run the math to know how much money I need to have invested so that 4% is enough to live on?
There's actually a very simple calculation to tell you how much money you have to invest for the 4% Rule to work for you. That number is the number 25.
Let's look at an example. Think about how much money you'll be spending each year during your retirement, your annual expenses. Take that number and multiply it by 25, and it will tell you how much money you need to have invested. If you were living like Mr. Money Mustache and his wife on $25,000 a year, $25k x 25 is $625k.
So, in order to retire, you would need to have $625,000 invested in the stock market and 4% of $625,000 is $25,000. That means each year, you'd be able to withdraw 4%--your $25,000–and live on that for the year.
That is how the 4% Rule works. Take your annual expenses in retirement, multiply them by 25 and that gives you the total amount you need to have invested in order to retire.
There are plenty of examples of people who have done this. If you'd like to read some of their stories, two of my favorites are the anonymous blogger of A Purple Life. This is a young woman who retired with $500,000 invested, which means she's living on $20,000 a year and she was able to retire at age 30.
Another example are the bloggers of Our Rich Journey. This is a married couple with two school-age girls and they retired on a total of 2.5 million dollars at the age of 40.
Even if you love your job and don't plan to retire anytime soon, it could be interesting to think about putting yourself in the position to be able to retire whenever you'd like. Keeping these numbers in mind and knowing how the 4% Rule works can be incredibly empowering on your own personal finance journey.
At very least, think about how much money you currently have invested in your 401k or any other accounts. Compare that with how much money you actually think you need to live on each year. How can you get your own investment portfolio closer to the point where the 4% Rule would work for you?
If the idea of early retirement sparks your curiosity, I would definitely encourage you to learn more. You can pick up my book, The Black Girl's Guide to Financial Freedom. You can read blogs of folks who followed this path. A few of my favorites are Mr. Money Mustache, A Purple Life, and Our Rich Journey. And if you want to read more about the investing side of things, one of my favorite books is The Simple Path to Wealth by JL Collins.
Here’s Your Homework
First, run the numbers for yourself. Think about how much money you would need to live on in retirement. And if you're serious about retiring early, get clear on the minimum amount of money you would need to spend in order to buy your freedom from needing to work. Multiply those annual expenses by 25 and get that target retirement number in mind.
The second thing I want you to do is check your understanding of the 4% Rule. How do we check for understanding? Try sharing this with a friend or family member and explaining it to them. You really know you understand something when you're able to teach someone else.
Finally I challenge you to learn more. Read inspiring stories, ask questions, and join the movement.