Retirement planning can seem like a dense jungle of confusion and jargon, which is why many financial planners like to rely on a few simple rules to guide our decisions, and easily the most important one is known as the 4% Rule. It’s a rule borrowed from the traditional finance world, and as with most of the “ideas” coming out of that world, it’s supposed to help people plan for their eventual, grey-haired, artificial hip-assisted retirement, but in practice just tends to discourage people from trying anything at all.
The Millennial Revolution, on the other hand, takes this decades old rule and twists it to our advantage, allowing us to retire years, sometimes decades earlier than we’re “supposed to.”
How? Well, let me explain. But first…
WHAT IS THE 4% RULE?
The 4% Rule, also sometimes known as the Rule of 25, came from a giant study into retirement planning and economic theory. Such a study that could change so many people’s lives would undoubtedly take on an almost religious importance, so fittingly it was named The Trinity Study.
Basically, the authors took all the price data from the stock and bond markets throughout all of recorded history, pretended they were a retiree starting with a bucket of cash at every year throughout that history, and simulated what would happen if that retiree withdrew a certain percentage of their portfolio every year and left the rest invested. Then they counted how many of those made up geezers made it to the end of their retirement with their cash intact, and how many ended up broke and dying alone in an alley surrounded by empty cat food canisters.
Picture a man named Allen. Allen has $500,000. But Allen needs $50,000 to live each year. So Allen’s withdrawal rate is 10%. Now let’s pretend Allen retired in 1975. He invests his money into the stock market, only selling assets every January to fund his next year’s living expenses. Does he make it? Or does he run out of money?
Now picture a woman named Betty. Betty has $650,000, but she only needs $26,000 to live. So her withdrawal rate is 4%. And Betty retired in 1982. She also invests her money into the stock market, and withdraws when she needs to pay her grocery bills. Does she make it? Or does she run out of money?
This mind numbing tedium is why so few people decide to become economics researchers..
But after countless hours of punching calculators (or more accurately, whipping grad students as they punched calculators), the Trinity Study came up with an answer. A withdrawal rate that had a 95% success rate. Meaning that out of the 100 made-up retirees, 95 of them made it to the finish line without running out of money. Here’s a picture of those 100 retirees.
How you read this crazy graph is that each colored line is a made-up retiree starting at a different point in time, and the vertical axis represents that person’s retirement portfolio while withdrawing the equivalent of 4% of their starting value every year, adjusted for inflation. Any retirement that dips below the red line ran out of money, while if it stayed above they were A-OK.
The vast majority, 19 out of 20, make it to the end of their retirement with their portfolios intact. In fact, most of them wind up with WAY more money than when they started with! From this study, the researchers determined that 4% was a reasonable Safe Withdrawal Rate, or SWR.
And I know, I know, to all the people who are getting outraged right now by the fact that 1 of those 20 people ran out of money, you are free to use 3% as your own personal withdrawal rate, which results in a 100% success rate.
So that means (assuming that you’re comfortable with a 95% success rate), once 4% of your portfolio matches your living expenses, you are officially retired. So flip off your boss, play his head like a bongo, and ride out of there on a rocket ship of glory! Your new life starts NOW! That’s where the Rule of 25 comes in. Take your living expenses, multiply by 25, and that’s your target portfolio size. Why 25? Because dividing your living expenses by 4% is the same as multiplying those same living expenses by 25!
WHY THE 4% RULE SUCKS
The reason that the 4% Rule is so discouraging is that it tends to produce these wild, scary numbers. Take Jill, for example. Jill works a nice office job, making $60,000 a year. Jill assumes she must be spending it all (since she doesn’t appear to have much savings), so she takes $60,000, multiplies it by 25, and determines she will need 1.5 Million dollars. Jill then takes the calculator, throws it out the window and resolves never to listen to a stupid finance blog again.
But that would be a mistake, because the mistake she’s making (and what most finance planners do) is link their post-retirement spending with her current spending.
This is wrong. Why?
WORKING IS EXPENSIVE
Think about how many expenses you have now that are directly attributed to your work. The fancy clothes, the fast food lunches, that car, even that condo right near the office are all expenses that are related to your workplace. All of that flies out the window the minute you leave.
And get even more creative than that. If you didn’t have to work, what would you do with your life? Would you go surfing all day in South America? Would you go live in a warmer climate and grow your own vegetables? Would you sit on a beach and drink margaritas? Those activities are actually far less expensive than you think.
WHO SAID ANYTHING ABOUT RETIRING ANYWAY?
My goal is to teach you to live freely, the way you want, rather than the life imposed by others. It does not require you to “retire” in the traditional sense.
Try to visualize what your ideal life would be. I know, it’s hard. So many of us are so busy paddling just to keep our head above water, we’ve forgotten what true freedom even feels like, but pretend you have it. Pretend that someone’s promised to take care of your rent and your basic needs for a year. Now what does that person do when they wake up every morning? Many of us wouldn’t just lie there in bed and do nothing. Millennials are too intelligent, and intelligent people get bored quickly.
Maybe you actually enjoy parts of your job, so you go down to part-time work. Maybe you move across the country or find a lower-paying, but more fulfilling version of that job. Maybe you finally write that great American novel you’ve been putting off. Maybe you’ve always loved arts and crafts, so you design purse ornaments and sell them on Etsy.
If any of those activities earn any money, no matter how small, that needs to get factored in, which the 4% rule doesn’t.
PUTTING IT ALL TOGETHER
I’d like to present the new and improved 4% Rule. It goes like this:
- Take your basic living expenses, AFTER you’ve attained freedom. Be as aggressive in making this number as low as possible, counting only basic living costs, and absolutely feel free to use Geographic Arbitrage as you see fit.
- Then subtract any income you can expect from doing work that truly fulfills you.
- Then multiply THAT by 25.
I’ll use a friend as an example. A highly paid engineer working for a Silicon Valley company, the living expenses of his coworkers were sky-high, easily $50,000 to $80,000 USD a year, and he had to jump through all sorts of hoops to get that down to something reasonable. But after he left and started travelling the world, he realized how much cheaper it is to live in nearly any other city in the entire frigging WORLD. He fell in love with SE Asia, and over there, he can live extremely comfortably for less than $20,000 USD a year. Seriously, he can sit on a beach in Thailand or Vietnam every day drinking margaritas for a fraction of what I was spending while I was working. And on top of that, he also picked up some freelance IT consulting contracts, since he still loved coding and wanted to keep doing it. HeI also wrote and published a children’s book. These activities have earned him about $15,000 USD.
So by applying the new 4% Rule, his target is ($20,000 – $15,000) x 25 = $125,000.
Not so scary now is it? This means he could have left his full-time job WAY earlier if he had known this formula back then. In fact, this means that he ended up amassing WAY more than he needed to.
So take a moment, visualize what your Ideal self would be, where they would live, what they would do each day, and calculate your new savings target using the new 4% Rule. Just remember this still requires you doing something on the side to make money not just sitting on the beach sipping on margarita’s all day.