The 4% Rule is a widely recognised guideline used in retirement planning to help individuals determine a sustainable withdrawal rate from their retirement savings. The essence of the rule is that retirees can withdraw 4% of their total retirement portfolio in the first year of retirement, and then continue withdrawing the same amount, adjusted for inflation, each subsequent year. The goal of this rule is to provide a steady income stream while minimising the risk of depleting savings over the course of a typical retirement, often assumed to last 30 years.

The rule is particularly popular among financial planners and retirees for its simplicity and practicality. It also seeks to offer a straightforward method for planning retirement spending without requiring complex calculations or ongoing portfolio management. The 4% figure is designed to strike a balance between providing enough income for retirees to live on comfortably and ensuring that the portfolio lasts long enough to cover the entire retirement period.

Key assumptions of the 4% rule

• 30-year retirement horizon: The rule is based on the assumption that the retiree will live for 30 years after retirement.
• Balanced portfolio: The 4% rule assumes that the retirement portfolio is diversified, typically consisting of a mix of 50-75% equities (stocks) and 25-50% bonds.
• Annual inflation adjustments: The rule includes adjustments for inflation, meaning that the initial 4% withdrawal is increased each year to maintain purchasing power.

The 4% rule is especially important in markets like the US where capital growth (i.e. increase in share prices) is the main way in which shareholders earn returns. In such markets, investors must make a conscious plan to sell down their portfolio to generate their retirement or financial independence income stream. In markets such as Australia where dividends make up a much larger proportion of total return to shareholders, selling down their portfolio may not be the main strategy.

For example, since 2000 the US Sharemarket (S&P 500) has had a return of ~7.5% per year, ~5.5% per year in capital growth and ~2.0% per year in dividend yield. On the other hand, Australia (ASX 200) has had ~8.1% per year total return, ~4.0% capital growth and ~4.1% per year dividend yield. As you can see, Australia’s sharemarket’s dividend yield as a percentage of total return is about 2x America’s. Fundamentally this is due to franking credits , but that’s a topic for another time.

Use of the 4% rule in the Financial Independence community

The 4% Rule has become a cornerstone in the Financial Independence, Retire Early (FIRE) movement, where individuals aim to achieve Financial Independence much earlier than the traditional retirement age. In the FIRE community, the 4% rule is used not just as a retirement planning tool, but as a benchmark for determining when one has achieved Financial Independence.

Financial Independence calculation

• 25x annual expenses: The 4% rule translates to the idea that once you have saved 25 times your annual expenses, you have reached Financial Independence. This is because withdrawing 4% of a portfolio worth 25 times your annual expenses would cover those expenses.
• Early retirement planning: FIRE adherents often retire in their 30s, 40s, or 50s, well before the traditional retirement age. They use the 4% rule to estimate how much they need to save to sustain their lifestyle indefinitely without relying on active income.

Adaptations within the FIRE community

• Flexibility: While the 4% rule provides a guideline, many in the FIRE community plan for flexibility in their withdrawals, especially in the early years of retirement. Some might aim for a lower withdrawal rate (e.g., 3-3.5%) to provide a buffer against market downturns or to account for a potentially longer retirement period.
• Income streams: Many who pursue FIRE also develop multiple income streams, such as rental properties, side businesses, or dividend-paying stocks. This can potentially supplement or reduce the need for portfolio withdrawals.

Origins of the 4% rule

The 4% Rule is rooted in the research conducted by financial planner William Bengen and later expanded by the Trinity Study. Here’s a closer look at how the rule came to be:

William Bengen’s research (1994)

William Bengen, a financial planner, was the first to develop the 4% rule in 1994. Bengen analysed historical data on U.S. market returns from 1926 to 1992 to determine a "safe" withdrawal rate that would prevent retirees from outliving their savings. He tested various withdrawal rates across a range of historical periods, including the Great Depression and other market downturns.

Bengen’s analysis concluded that, based on historical data, a retiree could withdraw 4% of their portfolio in the first year and then adjust that amount for inflation each year thereafter, with a high likelihood that the portfolio would last for at least 30 years. His findings suggested that 4% was the maximum "safe" withdrawal rate across most historical periods, even during significant market downturns.

The Trinity Study (1998)

The concept of the 4% rule was further validated and popularised by the Trinity Study, conducted by three professors at Trinity University – Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz – in 1998. The study expanded on Bengen’s work by analysing the success rates of different withdrawal rates over various time periods using historical data from 1925 to 1995.

The Trinity Study focused on different withdrawal rates ranging from 3% to 12% and evaluated their success in sustaining a portfolio over 15- to 30-year periods. The study used a range of asset allocations, including portfolios of 100% stocks, 100% bonds, and mixed portfolios of stocks and bonds.

The results of the Trinity Study reinforced Bengen’s conclusions, showing that a 4% withdrawal rate, particularly with a portfolio balanced between stocks and bonds, had a high probability (above 90%) of success over a 30-year period. The study’s findings contributed significantly to the adoption of the 4% rule as a standard guideline in retirement planning.

Applying the 4% rule in the Australian context

While the 4% rule is grounded in U.S. market data and conditions, it has relevance for Australian retirees and those pursuing Financial Independence. However, there are key differences in the financial landscape that need to be considered when applying this rule in Australia.

Market differences

The Australian stock market, known as the ASX , has unique characteristics compared to the U.S. market. Generally speaking, Australian equities tend to have a higher dividend yield, which can provide a more stable income stream for retirees. However, the market can also exhibit different levels of volatility, and the concentration of certain sectors (like mining and finance) in the ASX might introduce additional risks.

Superannuation system

Australia’s superannuation system is central to retirement planning and Financial Independence. Superannuation is a compulsory savings program where employers contribute to employees' retirement funds. These funds are typically invested across various asset classes, including domestic and international equities, bonds, and property.

For those following the FIRE movement in Australia, the 4% rule can be applied to the balance accumulated in a superannuation fund as well as personal investments. However, retirees need to consider the government-mandated minimum withdrawal rates, which are age-dependent and increase as the retiree gets older. For instance, a retiree aged 65-74 must withdraw a minimum of 5% per year, increasing to 6% for those aged 75-79. These required withdrawals may affect the applicability of the 4% rule, especially in later retirement years.

Inflation rates

Inflation in Australia has typically been lower than in the U.S. over long periods, but it has varied significantly. When applying the 4% rule, it's crucial to adjust for Australian inflation rates to ensure that withdrawals maintain their real value over time. The Reserve Bank of Australia (RBA) aims for an inflation target of 2-3%, which should be factored into any retirement or financial independence planning.

Tax considerations

Australian retirees and those pursuing Financial Independence benefit from favourable tax treatment on superannuation withdrawals after the age of 60, where withdrawals from a taxed super fund are generally tax-free. This contrasts with the U.S., where withdrawals from tax-deferred retirement accounts are typically subject to income tax. This tax-free status in Australia might allow for a slightly higher withdrawal rate than 4%, depending on individual circumstances. Of course, tax situations can vary between individuals, so for further guidance, speak with a registered tax accountant.

Longevity

Australians enjoy one of the highest life expectancies in the world, meaning that retirees and those pursuing Financial Independence may need to plan for a retirement period longer than 30 years. A longer retirement horizon increases the risk of outliving savings, which may necessitate a more conservative withdrawal rate. This could drop to 3.5% or even lower, depending on personal health, lifestyle, and financial goals.

Adjusting the 4% Rule for Australia

Given these factors, Australian retirees and those in the FIRE community may need to make adjustments to the 4% rule:

• Consider a lower starting withdrawal rate: Beginning with a 3.5% withdrawal rate might provide a more conservative buffer, particularly for those planning for a longer retirement or early Financial Independence.
• Incorporate superannuation and pension payments: Integrating superannuation withdrawals with the Age Pension can potentially help to optimise retirement income.
• Adjust annually for inflation and portfolio performance: Regularly reviewing and adjusting the withdrawal rate based on inflation, market conditions, and portfolio performance can help ensure long-term sustainability.
• Seek professional advice: Given the complexities of the Australian financial system, working with a financial adviser who understands local conditions can help tailor the 4% rule to individual needs. This is especially true for those pursuing early retirement or Financial Independence.

In summary, the 4% rule can offer a useful starting point for retirement planning and Financial Independence. However, it must be adapted to the unique conditions of the Australian market and individual circumstances to ensure it provides a sustainable income throughout retirement.

Happy investing!