The 4% Rule is frequently used by those who want to achieve financial independence. We analyze what it is, how it is calculated, if it is still valid today, and potential alternatives to the 4% Rule.
- What is the 4% Rule and how is it calculated?
- What is the logic of the 4% Rule?
- Is the 4% Rule still valid today?
- Alternatives to the 4% Rule
What is the 4% Rule and how is it calculated?
Achieving financial independence is not for everyone. It requires work, effort and discipline. We must make money, save it, and invest it well. But we also need to calculate how much money we need to achieve financial independence.
The 4% rule tells us that we can stop working when our annual expenses are 4% of the value of our investment portfolio. From that moment we could live off the income generated from our assets without ever having to sell the principle.
Let us do some math to visualize it better. If we need $4,000 a month to live, that would be $48,000 per year. Because we probably have to pay taxes on capital income, we would need a bit more than that figure pre-tax. Assuming that taxes on capital are 20%, we would need:
$48,000/ (1 – 0.2) = $60,000
Thus, using the 4% rule, we would achieve financial independence when 4% of our portfolio was $60,000. If we do the math, our investment portfolio needs to be at least this big:
$60,000 / 0.04 = $1,5000,000
With investments of $1.5 million, in theory, we could stop working and live permanently on our capital, without it ever being depleted.
What is the logic of the 4% Rule?
The 4% rule is based on two important premises:
- Our expenses can be covered with 4% of our portfolio
- Our portfolio will always be able to generate enough income for us to live from it
That means our portfolio must generate a high enough return to pay us the 4% we need to cover living expenses, and increase in value in line with inflation. Therefore, if we expect inflation to average 3% per year in the future, our portfolio should have a return of 7% per year.
Obviously, the lower inflation is in the future, the better. And the higher it is, the worse. Because that is something beyond our control, it will be important to have most of our portfolio in assets whose price can go up if inflation rises: stocks, real estate, gold, and other commodities.
The return we need, which is 4% above the inflation rate, can come from both cash flows generated by our investments (e.g., dividends, interest and rental income), as well as selling part of an asset that has appreciated in values (e.g., shares that do not pay dividends, gold or commodities).
The important thing is that, in the medium and long term, our portfolio can achieve those returns with sufficient guarantees.
Is the 4% Rule still valid today?
While I think the logic of the 4% rule is very useful, 4% is probably no longer valid today. This is because financial markets have changed dramatically ever since the rule was first invented.
The data used to come up with the 4% rule is based on US bond and stock returns throughout the 20th century. Therefore, we have to be cautious in the 21st century.
First, we must emphasize that the United States has been one of the most successful countries throughout the 20th century. It has become a global superpower and not experienced any severe crises. That contrasts with most European countries.
As a result, the returns of their financial markets (both stocks and bonds) have been extraordinarily high compared to those of most other countries. Consequently, if we had used the returns from British, French, or Japanese financial markets, the 4% would not have been invented.
Second, and perhaps more important, the current state of the economy and financial markets makes us think that the returns of the coming decades will be lower than the averages seen in the previous century.
This is because interest rates have been very low since 2008, and while they have been going up in 2022 and 2023, it is unlikely they will stay at levels that were considered normal in the 1980s or 1990s. As a result, the expected returns from fixed income securities, such as bonds and cash, will be lower.
At the same time, such low interest rates mean that the rest of assets (stocks, real estate, gold) trade above their historical averages. High valuations translate into lower future returns, as the company generates less profit for every dollar we invest today.
Therefore, we should have some healthy skepticism before assuming that our investment portfolio will be able to generate a return that is 4% above the inflation rate without taking too much risk.
It is important to highlight that returns should be generated without too much risk, given that the 4% rule assumes that we can stop working forever.
Alternatives to the 4% Rule
If the 4% rule is too ambitious for the 2020s, there are alternatives. The simplest alternative is simply to be somewhat more conservative. Therefore, we can adjust the rule downwards. If we use 3%, for example, our assumptions would be a lot safer.
Obviously, this requires an even larger investment portfolios, but that may be the price of financial independence today. If we use the 3% rule, and we keep looking at $60,000 of pre-tax income per year, the size of our portfolio should be:
$60,000 / 0.03 = $2,000,000
As you can see, we now need 2 million dollars in investments to retire. Frankly, given the world we live in, I think it is better to use a 3% return rather than 4%. If the returns in the future turn out to be better than expected, great. But if you really want to be financially independent, your future cannot depend so much on financial markets behaving well in the future.
Finally, here is a table outlining how much capital you need based on your monthly living expenses, using both the 4% and 3% rules. We assume a 20% tax on capital income:
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