27 March 2023

The 4% Rule

When is enough enough?

So there was a massive event at work today. A huge event that really shocked us. A gigantic event that had us all gossiping and arguing in the office. This was an event that had nothing to do with our business, nothing to do with a news story, nothing to do with the corona virus and nothing even to do with someone’s dodgy marriage. 

So what was it?

Steve had won the lottery. One million pounds. £1,000,000.

It started as a rumour that got louder and louder as it reverberated around the department until eventually it was confirmed. Steve was a millionaire. Unfortunately for the Steve sitting next to me, he was the wrong Steve, the unlucky Steve. The Steve whose numbers didn’t come up. The Steve who still was not a millionaire. But that’s okay, I liked Steve.

Of course from here it doesn’t take a chess grandmaster to work out the clear and obvious next step for us all – argue about what we would each do with a cool million tell each other why everyone else’s idea were wrong. It eventually boiled down to one important question: would you retire or would you stay?

There were two camps in which my colleagues pitched their tents:

“You would never see me again”

or

“Of course not, you can’t retire on a million quid these days”.

So who were the people on each side of the fence? It was pretty simple in most cases – For those who didn’t believe £1,000,000 was enough, 7 of the 10 were coincidentally under 50.

And the other 3 – 

One who is 58 and has been holding out hope for the last 3 years for a redundancy pay off.

One who is 62 and “doesn’t really need it”.

And me. 

So who is me? If you’ve been reading my blog you’ll know I’m now 28, work in the engineering realm and have a background in nuclear energy. I’m also an avid fan of the FIRE movement (Financially Independent Retire Early).

So I asked the question… “What if instead of one million pounds your winnings were forty thousand every year?” (And no, unsurprisingly we didn’t worry about inflation).

The answers this time around were completely different; most of those who answered that they wouldn’t be able to retire with one million suddenly changed their tune and thought it would be easy with £40k a year. Sure there were still two guys who didn’t think they would be able to afford it, but hey, who am i to tell them how much their life should cost?

As I sat there I have to admit the whole conversation shocked me a little bit. I knew that in the last year or so since discovering FIRE I had begun to look at things a little differently but this was the moment that I realised exactly how much I had changed. It struck me that there really is a huge gap in people’s knowledge and understanding within the financial realm and my opinion is that a huge amount of this is due to the way that it is always conveyed as a massively complicated, risky and elitist area. An area in which the highly intelligent, educated and driven people that I work with do not believe they could possibly come to understand or interact with – “that’s not for me”, “i would lose all my money”, “let someone else deal with it”. 

So why do people think that they couldn’t generate £40k with 1 million pounds? Well it’s pretty simple (and a little sad) – Nobody has ever educated them. 

In that room as far as I was aware I was the only person with my own self managed investment portfolio. Was it huge? Unfortunately not. But it was mine and it was generating me an income every year that I did absolutely nothing to earn.

1 million pounds if well managed will earn you on average at least £40k every year for the rest of your life and the real sweetener; you’ll likely still have at least 1 million left over at the end. Think what you could do with this money, for me I could travel the world (conservatively) and explore all it has to offer me. You could tick almost all the items off your bucket list and still be a millionaire.

In my opinion it’s a crime that we aren’t all educated on these topics to at least a basic level.

I work in an ex-government industry and we have the best pensions around. The guy opposite me has well over a million in his pension pot… he’s the 58 year old who’s been hoping to be made redundant for the last three years, getting more and more bitter. What else could he have done with those three years instead? 

How Does the 4% Rule Work?

The magic of the 4% rule is in its simplicity as a concept. Its ease of use as a formula and the ability to very quickly determine the investment pot you require to become FI (Financially independent). It works on the principle that when you decide to quit your career you can withdraw the value of 4% of your investment that year and every year afterwards (and it allows for inflation). In real terms if you had £100,000 you could take out £4000 each year (plus an additional ≈ 3% each year)) for the rest of your retirement. 

The basis of the 4% came from what is known as the trinity study, it was developed by 3 professors of finance at trinity college in 1998 before updating the study in 2010. This study was undertaken to learn more about safe withdrawal rates and how likely retirees would be to run out of money early. During this study the 3 professors used all of the financial data from 1929 to 2009 and divided it into 15 year, 20 year, 25 year and 30 year rolling averages before portfolios were tested against the market returns in these periods. The portfolios tested were a mix of stock and bonds and the results can be seen below.

So delving a little deeper into the table we can see that the 4% rule is just a ‘rule of thumb’ and unfortunately is no absolute guarantee of success. The main area of concern is that the study was completed using historic data and unfortunately past data does not guarantee future results – although of course it is the best option we have without becoming clairvoyant.

What we can determine from the 4% rule is that it may be suitable for you or it may not and this is either dependent on your risk tolerances or your plan for poor performance which will be addressed later in this article. For myself I would potentially be willing to take a higher risk if it allowed me to either quit the day job a little earlier or spend a little more each year.

*Financially independent in this case meaning that your investments generate you enough of an income to continue your standard of living without having to work another day in your life.

The Formula

This formula provides the backbone of the FIRE (Financially Independent Retire Early) movement and thankfully it is extremely simple. FI is when your investments generate you an income equal to or above the amount you spend each year. The formula is as follows:

Yearly Spend x 25 = Investment pot required to be FI. 

That’s it, it’s that simple. 25 is the number used because 4% x 25 = 100%. If you plan to withdraw 5% of  your portfolio each year (however you are more likely to run out of money) then the calculation would be x 20 instead (20% x 5 = 100%). In reality the only time consuming factor is determining what your yearly spend is. Some peoples FI calculation may look like:

£20,000 x 25 = £500,000

£40,000 x 25 = £1,000,000

£100,000 x 25 = £2,500,000

Remember that when calculating your yearly spend you do not need to include what you are currently setting aside for investing at the moment. E.g. if you earn £40,000 a year but save £20,000 then you need an investment pot of £500,000 and not £1,000,000. For help with how to calculate your yearly spend an article will be posted soon and linked here.

How to deal with early bear markets (draw down less, get part time job etc.)

As discussed at the start of this blog the 4% rule is used because of it’s extremely attractive risk-reward ratio. From looking at the results of the trinity study we can see that not all portfolios will last the entirety of your retirement and this is usually due to one thing – an early and prolonged bear market (a bear market is when it down trends). It does not mean that the owners of these portfolios did anything different merely that they were unlucky in the timing of their retirement. If you have a £1,000,000 pot and plan to withdraw £40,000 each year but within your first two years the market crashes. Your portfolio may only now be worth £750,000 but if you follow the 4% rule you will continue to draw an ‘income’ of £40,000 each year which is now the equivalent of 5.33% each year. These early excessive withdrawals and the fact that you are now no longer pumping new money into your portfolio hugely increase the chance the owner will unfortunately run out of money.

However if this was reversed and the market performed well for the first 10 years of retirement you may have withdrawn £40,000 each year and be left with a portfolio value of £1,500,000. Now if the market crashed it would be extremely unlikely that you would ever run out of money.

So how do we deal with this?

Flexible Drawdown

One of the simplest methods to counteract a bear market and ensure that you never run your investments accounts dry is to simply be flexible with the amount you draw down each year dependent on market performance. Does this mean that the simple 4% rule has just become much more complicated? Not really, just take the value of your investments, multiply by 4% and it will give you your drawdown allowance for that year/month. Along with the flexible drawdown method being a tool to ensure you never run out of money it can also be a tool that can increase your standard of living of the markets perform well. Some examples can be seen below from a person who was unlucky to be struck by an early bear market which then slowly recovered:

Year 1 – £1,000,000 pot – £40,000 to spend this year

Year 2 – £800,000 pot – £32,0000 to spend this year

Year 3 – £700,000 pot – £28,000 to spend this year

Year 4 – £770,000 pot – £30,800 to spend this year

Year 5 – £870,000 pot – £34,800 to spend this year

Year 6 – £980,000 pot – £39,200 to spend this year

Year 7 – £1,040,00 pot – £41,600 to spend this year

Year 8 – £1,170,000 pot – £46,800 to spend this year

Year 9 – £1,340,000 pot – £53,600 to spend this year

Year 10 – £1,5000,000 pot – £60,000 to spend this year

Benefits of this method:

  • By only ever withdrawing 4% of your portfolio regardless of its value it is impossible end up with a pot of £0
  • It allows for greater confidence to finally make the leap to early retirement and the next step of our lives.
  • In the event of a well performing (bull) market the retiree can drawdown more than planned each year and enjoy a higher standard of living.

Negatives

  • It may not be possible to survive on less than 4% of your original retirement pot.
  • By having to reduce your spending in early years your retirement may not provide you with the enjoyment you had hoped for – nobody should retire just to sit at home and minimise costs.
  • More complex to withdraw a different amount of money each month/year 

Overall we can see that there are huge benefits to using this method in the event of an early bear market. However for someone who retires and needs to draw the full 4% of their original portfolio to live this may therefore not be a realistic option. If this is the case then one of the following options may be best to supplement the reduced 4% value.

  • Take up a part time job doing something you enjoy to ‘make-up’ the reduced value
  • Create a budget, track all of your spendings and then minimise costs by cutting out those that do not bring you value.
  • Geo-arbitrage – not an option that most may think of but explore the possibility of moving to an area with a lower cost of living (could be county, state or country). A blog post explaining this will be linked here at a later date

How to calculate your FI number

Now we know the formula we need to know exactly how to calculate your own individual FI number. As will all things it’s not quite as simple as it may appear due to the fact that individuals have different interpretations of what being FI is. In order to condense this down into simple levels you can take action against I have divided FI into three parts.

  1. Lean FI
  2. Traditional FI
  3. Fat FI

Lean FI

The first and easiest to achieve of the above three is lean FI. Lean FI in my definition is the minimum amount of money you require in your investment accounts to survive (using the 4% rule) if you never worked another day in your life. The 4% drawdown of your Lean FI investment pot must be able to cover the basic expenses of your life. To calculate your Lean FI number add up the following and multiply by 25 :

  • Housing (Rent/Mortgage + taxes and upkeep)
  • Grocery’s
  • Transport
  • Utilities
  • Phone
  • Internet
  • Healthcare (depending on where you live)
  • Clothing
  • Other necessities you have

By becoming Lean FI you no longer need to worry about working a job you hate or being made redundant and it also allows you to take greater risks in your career. If you want to retrain into a new field or start your own business then you have a safety net behind you that will ensure that you still have a roof over your head regardless of whether you make your new path a success. By becoming Lean FI and gaining this confidence it is extremely common to see people begin to excel in careers as all of a sudden you begin to hold the cards in negotiations instead of your employer. Lean FI is where I would consider leaving the workforce to begin working on my own projects and side hustles.

Traditional FI

Next we have Traditional FI which is what most people (and myself) refer to when they talk about financial independence. Traditional FI is a step above Lean FI in that your 4% drawdown provides you with enough money to maintain the same standard of living as you are currently enjoying. Where Lean FI only provides the bare necessities to survive, Traditional FI gives you enough money each year to live exactly as you were pre-retirement. To calculate your Traditional FI number multiply the following by 25 and add to your Lean FI number:

  • Holidays/Vacations
  • Hobbies
  • Luxury goods
  • Luxury food/dining – Wine, restaurants, cocktails etc.
  • Gifts for friends and families
  • Any other common purchases you currently make and enjoy

Traditional FI is likely where most would consider leaving the workforce to spend their hard earned freedom to follow individual passions and loves. This might include hobbies, travelling, charity work or simply more time with children and loved ones. It is at Traditional FI where you can never earn another penny in your life and still live a fun and fulfilling life.

Fat FI

Fat Fi is simply the opposite of Lean FI. When following the Lean FI principles and retiring you can only draw down enough money to cover the very basic necessities of life. This will mean that unless you either earn money from a side hustle or inherit you will live a life of a financially poorer standard than while you were working.  However with Fat FI you will be able to draw down more money from your investments than you would usually spend during your working life. This allows for a much more exuberant lifestyle which is enticing for many of us. To calculate your Fat FI number multiply the following by 25 and add to your Traditional FI number :

  • Multiple luxury vacations each year
  • Fancy car
  • Bigger house
  • Financial help to children/family
  • Holiday homes
  • Expensive hobbies
  • Boat
  • Regularly eat at restaurants
  • Anything within reason that you desire

Looking at the above list it is obvious why Fat Fire is the goal for so many people but predictably it comes with a cost for each person. There are two downsides to Fat Fire:

  1. You need to work for a longer period of time to reach this milestone
  2. By working for longer you will have less years in your life to enjoy your retirement

Often the choice to work towards Fat Fi will depend on your current job for the reason that if you have worked your way up to a high paying position it may be worth extending your career for a minimal number of years to significantly increase your net worth. Also if you gain a lot of pleasure from your career and enjoy it each year then there is no huge rush to leave.

By looking at the three versions of FI there is a noticeable trend; to achieve a higher standard of living post FI you need to sacrifice more years of your life to work. The only way around this is to find something that allows you to make money which provides fulfillment and enjoyment.

Actionable Steps

  1. Separate your personal expenses into different categories
  2. Calculate a rough figure for each category
  3. Calculate your Lean FI number
  4. Calculate your Traditional FI number
  5. Alone or with partner/family discuss what your dream retirement life would involve
  6. Roughly calculate would you believe this lifestyle would cost
  7. Calculate your Fat FI number
  8. Using a budget planner begin to accurately track your expenses each month

In the UK last year (2020) the average spend per household was £30,571 per year. This correlates to having a Traditional FI value of £764,275. One point to note is that this value was calculated with an average of 2.4 people per household and therefore if your post FI life does not revolve around looking after your children this will likely reduce.

Hopefully this article will allow you to calculate your own individual FI numbers and begin to set your own targets. Initially these goals may seem as far away as the moon but with the power of compound interest doing the majority of the work in your later years, the first steps are always the hardest.

thenomadwallet

A 28 year old project engineer with a passion for travelling, financial literacy and learning new skills. I'm hoping that by running this blog I can track my path from corporate worker to backpacking adventurer.

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