The 4% rule for early retirement is a ‘bad idea’

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If you’re hoping to retire early, you’ll need to find a way to replace your salary without working. In a traditional model, this means accumulating enough savings to be able to withdraw some of it each year to fund your lifestyle while the rest continues to grow.

Unless you win the Powerball, how much should you save? Followers of the FIRE movement – ​​short for financial independence, early retirement – ​​aim for a goal of 25 times your annual retirement income.

The figure, known as the “FIRE number”, is based on the idea that you can safely withdraw 4% from your portfolio per year, adjusted for inflation, without running out of money. This “4% rule” comes from a 1998 research report known as the “Trinity Study,” which looked at historical market performance to determine a safe retirement withdrawal rate.

But here’s the thing: The Trinity study numbers were aimed at people looking for a traditional retirement in their mid-sixties. When it comes to using it as the sole basis for your early retirement, the experts are skeptical.

“I think it’s a terrible idea,” said David Blanchett, managing director and head of retirement planning at PGIM, at a recent seminar. “The 4% rule is by definition for a 30-year retirement horizon. You shouldn’t use it before age 50.”

Consider smaller withdrawals for a longer retirement

It’s not like proponents of early retirement misunderstand the study. Although the Trinity study assumes a 30-year retirement, the compound nature of investment returns means the calculations can be applied over longer periods, experts say.

“When you actually look at the math and stretch it over a longer period, in most cases your money will triple or quadruple,” says Grant Sabatier, a leading figure in the FIRE movement and creator of the financial site Millennial Money. “That’s the nature of a compound curve.”

But extending your retirement length widens the margin for error in your portfolio, experts say. This means that it may be wise to aim for a slightly lower withdrawal rate the longer you expect your money to last. Morningstar researchers say a safe withdrawal rate may be between 3.3% and 4%, for example.

“In general, if you have a portfolio balance and plan to spread your withdrawals over 40 or 50 years, starting with a lower withdrawal rate gives you a higher likelihood of success,” said Christine Benz, director personal finance and retirement. planning at Morningstar, Make It told CNBC.

Aiming for a lower withdrawal rate means you’ll need to save more money if you want to fund the same lifestyle. According to the 4% rule, multiplying your income by 25 is actually dividing it by 0.04, so if you want to live on $40,000 in retirement, you’ll need $1 million. If you plan to withdraw 3.3% per year instead, your FIRE number jumps to $1.2 million.

Use the 4% rule flexibly: “Life is life”

Even though adjusting your withdrawal expectations improves your odds, it’s still a good idea to avoid sticking to hard mathematical rules when it comes to funding your retirement. After all, when did the rest of your life go exactly as planned?

“Research has shown that a more dynamic approach to spending in retirement would be appropriate,” says Nilay Gandhi, senior wealth advisor at Vanguard. “That’s life.”

In other words, hitting your FIRE number doesn’t mean you can stop actively managing your financial life. Quite the contrary: blindly withdrawing the same amount of money each year increases the chances that a bear market could deplete your savings to the point where you run out of money.

Instead, retirees can take a “dynamic” approach to withdrawals by withdrawing more when the market is bullish and less during bearish markets.

This will require a bit of planning ahead of time. Gandhi suggests that any young retiree should constantly review their goals and spending habits, both before and during retirement. Having a budget you understand and can actually follow will make adjustments easier, he says.

It’s also essential that you plan for unexpected expenses, “like an illness that occurs that isn’t covered by certain types of insurance,” says Gandhi.

FIRE experts recommend building a strong cash reserve that can save you from having to withdraw money from a declining portfolio. Sabatier keeps two years of cash outlay as a “buffer” to ensure he doesn’t have to sell his investments for emergency cash during a market downturn.

That way, he says, “I don’t have to make those hasty decisions when the market is down.”

Want to earn more and work less? Register for free CNBC Make It: Your Money Virtual Event on December 13 at 12 p.m. ET to learn from money masters like Kevin O’Leary how you can increase your earning power.

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