4% Rule - how it all started and the assumptions behind

Everyone that has read something about the FIRE movement must have come across the "4% rule" pretty early on. It is often summarized at its most basic: if you have a certain amount of capital, you can withdraw 4% from it every year and live off that money for a relatively long period of time. 


Often the origin or the assumptions behind are barely mentioned if not mentioned at all and the "4% rule" is accepted - exactly as the name suggest - as a rule. While we have done some work already on testing a similar approach with the portfolio visualizer tool (see here or here), here I would like to give more background on the this seemingly infallible rule of personal finance. 


As far as I could trace back, the honor of having introduced the 4% rule to the world goes to William P. Bengen in a paper called "Determining withdrawal rates using historical data" (freely available here) in 1994. 

The topic was then picked up again by three professors at the Trinity University in 1998 in what became known as the Trinity study (original title of the paper: Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable - freely available here).


The two studies have similarities as well as differences, so let's compare them together:


One of the first aspect that should strike you is that both studies seem to be very much USA focused - the Trinity one mentions explicitly that their reference for Stocks is the S&P 500, while Bengen is not explicit about it. 


The second point is that the Trinity study has a very short timeframe if we talk about a FIRE mindset. Considering the current life expectancy (80+ years old), a bit of buffer and the ambition to retire early, 30 years are just not enough to take all of this into account. Therefore, at least from this point of view, the Trinity study has little to do with the association to the FIRE movement. 


Last but not least, both studies completely exclude taxes and most likely transaction costs. When you start to withdraw your capital - assuming you will sell your assets - you will have to pay a capital gain tax depending on the country you live in. If you live in Germany, for example, you will pay 26.4% of your capital gain to the German State. That is not a small amount - but it is extremely difficult to consider in such studies as legislations can be wildly different depending on the country. The transaction costs exclusion is also not trivial: if you invest in a ETF with a TER of 0.2%, you will pay that every year as lower return vs the index (this is captured by the tracking difference between the ETF and the Index as far as I understand). 


Beyond this, you are probably already familiar with the results - those are usually portrayed with a sufficient level of details:

  • Withdrawal rates of 3-4% have high success rates within the timespan considered (30 years for the Trinity study!) - and they are even considered "too conservative". The longer you want your portfolio to survive, the lower your withdrawal rate should be. If your time horizon is very short - 10/15 years, withdrawal rates of 6% with a portfolio skewed towards stocks would have a 90%+ success rate (Source: Trinity Study) even accounting for inflation. 
  • The presence of bonds (25%) in the portfolio helps to increase the success rate of the portfolio for mid-low withdrawal rates (4% and 5% for certain time horizons), however - for high withdrawal rates - bonds do not offer high enough returns and you would be better off with stocks. 
  • Inflation is a portfolio success rate killer - but why wouldnt you want to take it into account? For long timeframes, that would be a suicide. 

Just remember - all of the above is based on a USA focused investing strategy that does not include taxes or costs and whose time horizon is mostly 30 years!

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