The 4% Rule: Early Retirement Explained

How to retire early? Many people desire early retirement, and the 4% rule can provide assistance, despite its drawbacks. Let’s explore what it entails.

Early retirement is a dream for many working individuals, as it allows them to enjoy their savings while they still have the energy to do so. However, with the retirement age increasing almost every year, this opportunity often arrives later in life. The 4 % rule is one approach that can help people achieve their goal of early retirement. In this article, we will examine the 4% rule, including its benefits and drawbacks.

Early retirement and the 4% rule: the origins 

The 4% rule originated in the United States, a country guided by the Latin proverb “homo faber fortunae suae,” which means “man is the author of his own destiny.” This mindset encourages citizens to rely on their own abilities rather than depending heavily on the government. As a result, Americans often gain familiarity with investments from a young age, driven by the belief that their future largely depends on their personal actions. This mentality has led to the development of various financial theories related to savings and retirement, including the popular 52-week challenge and the 4% rule that we will discuss today.

William Bengen, an aerospace engineer born in 1947 in Brooklyn, New York, is the inventor of this principle. He earned a master’s degree in financial planning in 1993. The following year, he published an article titled “Calculating Withdrawal Rates Using Historical Data” in the Journal of Financial Planning. In this article, Bengen analysed extensive historical data on the U.S. market and discovered that it is possible to sustain oneself on savings for up to 30 years. His method involves withdrawing 4% of one’s investment portfolio each year and adjusting this amount for inflation starting in the second year.

It’s essential to recognise that the American pension system differs significantly from European systems and is structured around three primary pillars: social security, private pension funds, and personal investments, including Individual Retirement Accounts (IRAs) and 401(k) plans. A key aspect that helps us understand Bengen’s strategy is that the 4% rule is based on the idea that pensions are “dynamic” rather than static. This means that when Americans save for retirement, they typically invest their money in a variety of assets, including stocks, bonds, exchange-traded funds (ETFs), and mutual funds. As a result, their pensions tend to grow over time. The 4% rule is designed conservatively, suggesting that this withdrawal rate would generally provide enough income to live comfortably for roughly 30 years. 

To illustrate this point more clearly, let’s examine a concrete example.

How does the 4% rule work?

To determine how much capital you need for retirement, start by calculating your average annual expenses. Once you have this figure, divide it by the %age you plan to withdraw annually, which is typically 4% (or 0.04). 

For example, if you anticipate needing 15,000€ per year for expenses (which breaks down to 1,250€ per month for 12 months), you would divide this amount by 4%: 

15,000€ ÷ 0.04 = 375,000€. 

This means you should aim to have 375,000€ in investments. According to Bengen’s perspective, this capital would be invested in the stock market and would generate an annual return.

Great! You can stop working and enjoy your free time. In the first year, you withdraw 4% of your initial amount, which is €15,000. From the second year onward, you will adjust your withdrawal amount to account for inflation, specifically increasing it by 2%. This means you would withdraw €15,300 in the second year, and continue to adjust this amount annually based on inflation. Meanwhile, the invested capital is expected to generate enough profit to cover these withdrawals, allowing the portfolio to remain sustainable even during years when the market does not perform as well as expected. However, there are some caveats to consider.

Bengen’s early retirement fails to grasp some critical issues

First of all, it’s important to recognise that this is a purely theoretical rule and may not accurately reflect real-life situations. While calculating average annual expenses can be helpful, it doesn’t account for unique circumstances, such as wanting to take a trip to El Salvador or managing unexpected costs like car repairs. In these instances, you may need to reevaluate the amount you plan to withdraw to cover these unforeseen expenses—unless you have a dedicated emergency fund set aside.

Additionally, it’s crucial to consider the costs and fees associated with managing your investments. The Total Expense Ratio (TER) encompasses all operational expenses of a fund, including those related to mutual funds or ETFs. These fees can significantly impact your net investment return. If you decide to work with a financial advisor, their fees will also be factored in. For example, a gross return of 7% could ultimately result in a net return of only 5.5% after deducting these costs. Keep in mind that every euro spent on commissions is a euro that isn’t working toward your future. If you’re interested in experiencing life in a country that has adopted Bitcoin as legal tender, consider planning a trip to El Salvador. You can also explore clubs offering discounts through WeRoad. Furthermore, join the Young Platform to stay updated on relevant guides and news!