The 4% Rule And The Implications For Retirement

Posted by E.A. Mann on April 2

In the world of personal finance writing, we love to talk about something called the 4% rule. This rule came out of a study done in the States in the 1990s, and has been updated a few times since then. It imagines a person with a lump sum of money who wants to retire and live off of that money for thirty years, then looks at how much money that person could safely spend if they retired each year for the past 100, and tries to come up with a worst case scenario.

The study concludes that a person should be able to spend 4% of their invested money in their first year of retirement, and then increase that withdrawal yearly by the rate of inflation. Under this scenario a person with £1 million invested could spend £40,000 each year, adjusted for inflation, and would not have run out of money in any thirty-year period starting in 1925.

Hence, 4% is believed to be the safe withdrawal rate if history is any guide. It’s great to have this percentage for planning purposes, but it can lead to some depressing realisations. For example, if you need £100,000 in income to support your life, you’ll need £2.5 million to retire. To many people, this number is so high that it may as well be infinity.

And your yearly spending number doesn’t address taxes, fees on your investments, or the fact that real people don’t have a consistent “yearly spending” number. For the last ten years I spent exactly zero pounds each year fixing my roof, and last year I spent thousands. How does that factor into my “yearly spending” number?

But there’s good news. Like all maths, it also works in the opposite direction. For any wage or income you receive, just multiply it by 25. This tells you how much this income is “worth” as a lump sum under the 4% rule. Income here could be a state or private pension, rental income, or just a wage from a part-time job.

So if:

£1 Million lump sum = £40,000 yearly income (4% rule)

Then it’s also true that:

£40,000 income = £1,000,000 lump sum (also 4% rule)

This is what I call the Super Income Lever.

What I’m trying to say here is that even small amounts of income can replace huge amounts of retirement savings. And since you probably receive some kind of income, it means you probably need much less wealth than you think to retire.

To this, add two facts: that people often don’t enjoy their jobs, and that many who retire don’t actually stay retired. Ponder this quote from financial planning expert Michael Kitces: a large number of his client have “insisted on getting to their pure, standalone financial independence number because they never ever, ever, ever wanted to have to work again, and within three years they were working again.”

Humans crave meaning in their lives, and often that meaning comes through work. That work, even if it’s part-time work, or work with a charity, often produces some amount of income.

Written by E.A. Mann

E.A. Mann is a systems engineer and freelancer who specialises in finance writing. He is passionate about breaking down complex investing concepts so that everyone can understand them, not just the experts.

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