S2E8 - The 4% Rule...What You Don't Know Can Hurt You!
What is the 4% Rule?
A: It seems like even the people who seem to think that they know what the 4% rule is, and once they start talking, you kind of realize that everyone has a different impression of what the 4% rule is. And when you start actually digging into it, you discover that it isn't quite what anybody thinks.
What People Think The 4% Rule Is
The media and people have this idea that the 4% rule is, if I only took. 4% of my portfolio every single year. I would never run out of money in retirement. People have latched onto that idea from different studies, and when you start diving into it, you might start to question whether it's something you actually want to rely on.
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What the 4% rule is really trying to do is predict the future.
And we both know, right? You can't predict the future. So then we start looking in the past, and we go, Okay, historically, things have happened. So if historically, if things continue to happen as they have and the future. Is like the past, then therefore this would be a safe number.
Right? And now we're starting to read into the tea leaves. And so if you don't even know what the assumptions are behind the tea leaves that you're reading, then before you know it, right? You're, who knows what you're building on.
The 4% Rule Says You Need 25x to 30x Your Annual Expenses Saved
So when we think about the 4% rule, right? Another, another way of phrasing that is you've probably heard, you know, uh, save 25 to 30 times your annual expenses, right? That you should have, that your retirement number, that the amount that you should have saved should be 25 to 30 times what you spend in a year.
Mm-hmm. . If you think about it 25 times, right? So if you took one and you divide by four, it becomes 25. Ah, yeah. So the 25 rule, 25 x rule, right, of 25 years or 30 years is essentially saying the 4% rule, right? It's a mirror image of that. Um, but it's for different reason. Um, and that's kind of where people come up with this number of how much money should you have saved up for retirement.
It's based on this 4% concept that if you somehow took out only 4% a year, that you would be okay. Right? And. It's, you know, is it based on something? Well, let's talk about that. But that, that is what it's based on. It's based on this idea that if you somehow only took 4% a year, you would never run outta money in retirement.
And let's just, you know, between the two of us, let's be honest, right? Realistically speaking, there's a lot of people who may not even have that much money in savings, right? They might not have 25 times their annual expenses save. So are we telling all of these people that they can't retire? Right. And if we're telling these people that they can't retire, Right?
Well, reality has a different outlook. Right? Reality is, well, these people can't work anymore or they, they're not getting a job anymore. They get fired. Right? Or they're forced into retirement. Mm-hmm. . But now, right? So there's this whole world of people. Just, you know, they got to 65 or they got to 70 or whatever that year was, or they had an injury at work and it forced 'em to retire and they don't have 25 times their annual expenses saved.
They don't have, you know, enough that they can take out 4% every year and be okay. So are we telling these people they're not safe, that they're gonna run outta money in retire? Um, and I think when we start diving into, you know, what, where the 4% rule came from and you start looking into it, you might question and say, Well, okay, maybe I don't actually need that much money saved in retirement.
Maybe I could take out more than 4% and still be okay.
Is the 4% Rule Something You Can Live By?
I think that as a rule of thumb, right, if you are, if you're trying to gauge whether you have enough money for retirement. if we only took 4% out of our portfolio, out of our life savings and that covered our expense needs in retirement, then we are doing awesome, right? Because I, we can definitely create a retirement plan around 4%.
if 4% is not enough, right, and you still have a shortfall, I don't think that you should at that point give up and say, Well, I have to work longer, or I have to cut my expenses. I think it just means you gotta be a little more creative in how you structure your retirement because that just means that this rule of thumb doesn't apply to you and you're gonna need to use other factors to fund your retirement.
What is the Trinity Study and How Does it Apply to the 4% Rule?
So the Trinity study, which everyone kind of like looks to and calls, you know, the 4% rule or the Trinity, you know, the Trinity study, which was, you know, Trinity University, which is where these professors were, actually came on the backs of another study that was done by a retired financial advisor, Uh, John Big, um, if I'm pronouncing his name right, I, and he's, you know, both them and the people who created that Trinity study have come out multiple times over the years.
Updating their rule. Um, but let's let, let's talk, take a look at the fundamentals, right? Both be and the Trinity guys, right? What they looked at was, they said, Let's start with the question of how mu, how, how, how can we structure a portfolio so that someone would not run out of retirement money during retirement, right?
So that they would not deplete all of their savings by the time that they died. That was the question that they asked themselves right now. They said, Okay, how are we gonna structure this? They, this was, you know, 1998 was the first study that was done by the Trinity University, right? These guys. So they went back historically and they looked 1925 to 1995.
And they looked at different periods of the stock market and the bond market, and then they looked at the returns and they were like, Okay, what percentage could we take out of a portfolio over a 15 year period or a 25 year period that if we took that percentage would consistently allow the person retiring to still have money when they died? Or at the end of that 15 or 25 year period.
Assumptions That No Longer Hold True About the 4% Rule
let's look at some of the assumptions of this study. Okay.
Assumption number one is that the past is gonna look like the future
We starting in 19, right? 1925 to 1995. Right. Let's talk about all the changes that underwent the world, right? We're, we're talking about, you know, coming off of World War I, right? World War I. Right. Um, we have, we have Cold War, we have the space race, We have hyper inflation, right of the seventies. We had Soviet Union in 87, right?
Defaulting on their sovereign debt for the first time. Collapse of the Soviet Union, right? And then we have the.com boom. So this was literally in the height of the.com boom, was where the study ended. Um, and the first study in 1995, during that period, also, by the way, right? We went off the gold standard.
So in 1925, a dollar was worth a dollar of gold. You can go and exchange that dollar bill for a dollar of physical gold that you can buy things with by, you know, 1970, you couldn't do that anymore. And that completely, that's part of what drove inflation and that completely changed economics. We had globalization, we have technology, right?
The world did not look the same. The stock market did not look the same. 1925, you wanted to buy stocks. You literally went down to Wall Street. But nowadays, right? You wanna buy a stock, you go online on Robin Hood, and you can have that within a few seconds.
What validity does the 4% rule still have for us today?
I think that concept that you should look to the past and then say based on that what I can expect the future to look like, let's use some statistical analysis to say what we can take out of our retirement each year. I think that was the innovation that they did, that they introduced this concept to the finance world.
Like, Hey, don't just guess at this. Do you some analysis. But beyond that, the numbers change. They literally change, you know, every few years. Because the stock market, depending on whether we're in, in a beer market or a bull market, will determine what the future expectations are for the return on the market now over a long enough period.
Yeah. Those numbers will kind of even out. But I, I, I mean, I, I think everyone will agree that the bond market has changed significantly from 1925 to 1995 or even to, you know, 2015, um, or 2022. Right. Exactly. And, and what's gonna happen in the future, right? It's not going to mimic what happened in the last 20 or 40 or 50 years.
How Do You Use The 4% Rule In Your Retirement Planning?
So first of all, the further away you are from retirement, the more the 4% rule is a good rule of thumb. Ah, uh, it's when you actually get to the point where you're like, Well, I need to start taking money out of my account, right?
I actually need to retire. Do I have enough money that the 4% rule becomes a, a problematic? Now, here's, I do use the 4% rule in my planning, but I use it in the way of saying, are we, do you know, do we have a thumbs up of like, we have enough money or do we need to do additional work? To see, do we actually have enough money to retire?
Because if we have 4%, the way I look at it, right, it, the, the stock market, when we look at the historical returns of just the s and p 500, so you're just invested in the top 500 companies and the United States. When we look at the historical return that that has had over the last 200 years, that has averaged 6.7%.
After inflation. So that means no matter whether inflation was like 10% right, or inflation was, you know, 1% after inflation, statistically that has returned an average of 6.7%. So if I only take 4% from that, that still leaves me with 2.7% to put towards next year's retirement and my future, right? So I'm still accumulating wealth over the long run.
Probably end up hurting you as any financial planner will tell you, but as a rule of thumb, do you have enough or not? Or do we need to figure out how to cut expenses or increase our income? I think is a good rule of thumb because worst case scenario, You know, a hundred percent invested in the stock market, which everyone says not to do, right?
But if you had to, you could be a hundred percent invested in the stock market and you would be okay. Right. So I see it as kind of a green light, red light thing of are we, are we safe to proceed with our retirement planning or do we have more work to do?
What if I don't Have Enough Money?
So you're not in trouble, Right? I, I would say that right off the bat, right? Just because you're gonna run outta money, just because it says you're gonna run outta money doesn't mean you're gonna run outta money, right?
Because it is trying to project into the future. It's trying to look at it crystal ball, It's making assumptions that may not be. Right. So what we wanna do, right when it says, when it starts fr uh, flashing red lights, all that says is one, we gotta be super careful about the decisions we make because every decision that we make is gonna have more of an impact on us than it will have on regular people, right?
So that's number one. Number two, it means we probably will have to get creative. Like, something that I didn't mention about the Trinity study is they found that that 4%, it went along with a portfolio that was 50% equities, 50% bonds, which right now anyone would tell you would be nuts. So the, you know, they, over time that changes and it's all based on, you know, what historical returns and what the projected future returns are.
Mm-hmm. . So we may need to take on more risk or we may need to say, you know, we need to. Prepay some of your expenses to bring those expenses down, right? There are things that you can do. All it does is it says where you need to focus your planning. It does not tell you whether you can retire or not.