Most FIRE followers live by 4% rule. Also known as the Safe Withdrawal Rate (SWR). In this article, I am breaking down the 4% rule, looking at how it works, how safe it is, how to calculate your retirement corpus and if it will work for someone living in India.
What is the 4% Rule
Let me start of by being technically right. It is actually not the 4% Rule, as it is not really a rule. Instead it is a finding in a study (more on this later), however since the term has stuck, I shall continue calling it a rule. Now, the 4% rule is a method of calculating how much money you will need in order to retire from your job after reaching Financial Independence. The rule was from an old Trinity study by three finance professors from the Trinity University in 1998.
They tried to solve a question of when does a person have sufficient money to retire. To answer this, they ran a simulation on a fictional person who had equal investments in stocks and bonds. As a final answer, among other findings, the study also found that if a person can live on 4% of his investments & assets on the first year of retirement, then that is the point of retirement. In FIRE lingo, this works out as 25 times your annual expenses.
As an example, if my monthly expenses is Rs.1,00,000, then I need Rs.12,00,000 per year. 25 times 12 lakhs is Rs.3 Crores. This will be my magic number as per the 4% rule to retire. Other way of looking at it is, 4% of Rs.3 Crores is Rs.12,00,000 which is how much I need for expenses every year.
How is the 3% rule different from 4% rule?
3% and 4% refer to the % of money you withdraw to live every year from your investments. Trinity study says 3% is near foolproof and a lot more conservative. To calculate as per the 3% rule, simply multiply your annual expense by 33. That will be the retirement corpus you will need to retire under the 3% withdrawal rate.
How does this impact Indians? Does the 4% rule work in India?
Yes, the concept does work. However 4% withdrawal rate is a too high for those of us in India. The reasons being, the Trinity study was conducted in the US using data from US stocks and US bonds. Also, the inflation rate considered was of US, which was much lower. As of today, US averages around 1.5% Inflation while inflation in India is around 5%. So someone who blindly takes the 4% rule in India is bound to be on a tightrope and possibly get screwed later on if not planned and tracked correctly.
When I did my personal FIRE calculation, I had been conservative in my estimates. I did the hard math for calculating my retirement corpus and did not use the 4% rule which is kind of the lazier version. In the end, the amount I arrived at to stay retired in India for my somewhat luxurious lifestyle is around 3.4% SWR in the initial year.
Here is what I considered. I took inflation at 5%, Tax on income at 20%, Returns on Investment at 7.5%. With these, I got a Safe Withdrawal Rate of 3.4% which is for my somewhat luxurious lifestyle, if I were to retire with Rs.3.3 crores and a monthly draw down starting at Rs.1,00,000. In my opinion, a 3% rate of withdrawal should be a better fit for someone India.
How reliable is this?
Well, during the Trinity study, the professors ran the numbers from 1925 to 1995. Later, in 2009, the added data till 2008. As you can see, the numbers cover 1925 to 2008, which is through most major world events. World war, recessions, depressions, civil wars, terrorist attacks and a lot of other things happened that impacted global economies in this 80 year period.
As per their calculations, when a person has 50% of investments in stocks and the rest 50% in bonds, and withdraws 4% of assets the first year. Later increase this 4% to account for inflation year on year, then this person has 96% chances of never running out of money during the retirement time. All this assuming the person never earns additional money, nor does he inherit or get anything ever. So, according to me, this is pretty darn reliable. Even more so, if you are smart enough to re-calibrate and have course corrections periodically as you go.
FIRE Goals if something unexpected happens?
- What if I run out of money while in retirement?
- What if there is another world war or depression
- What if a UFO lands on my house killing me?
Well the professors in the Trinity study were clear about one thing. This 3% or 4% rules are just plans. Consider these as methods to plan for your financial independence and early retirement. This may change with fiascos and unforeseen events. Aliens may take over the world and your money may become useless, if that happens, investments will be the least of your worries. On the other hand, the study did not factor in a number of things that will help make your withdrawals from investments lower, thus increasing the success rate of your retirement.
Unexpected things happen, it is up to us to stay planned for it. This is where you recalibrate your plans to see where you are and how big an impact the unexpected event had on your FIRE plan. The 4% rule by Trinity has already considered the ups and downs in the market. For if there is a market crash, there is bound to be a market boom and this data has been factored in to arrive at the 4% number.
You can also make changes to your lifestyle to alter things if you are not too comfortable, then again there are several things that the 4% rule does not factor in that acts in your favor.
What the 4% rule and Trinity study does not consider:
- They assume that after retirement, you will not earn any money. FIRE enthusiasts are smart people who earn and stay active post retirement. Even if you are smart enough to have a side income stream that can bring your 3% withdrawal rate to 2.75% your success and increase in portfolio will be dramatic
- They do not consider any pensions, subsidies, government grants etc. In our case in India, we receive a number of subsidies, grants, medical care (if you are ok with Government facilities) and tax breaks.
- Windfalls are not considered. Inheritances from your family and relatives are not considered
- 4% rule assumes that your expenses will keep raising every year. Well, it is the opposite actually. As you grow older you will be reducing your expenses
- 4% rule thinks that you will be spending the same amount of money every year. Well, you are smart. You know that during recession you cant afford a holiday right? You are smart enough to cut back on luxuries during bad investment periods and take measures to save more such as rent a room to Airbnb or take up a side job etc when things are not going as per plan.
Questions on 3% & 4% Rule and FIRE Retirement corpus Calculations
Yes, the rule and the Trinity study do factor in inflation and increase/decrease in stocks and market. The study factored in an increased withdrawal rate year on year to allow for inflation. Simply put, the 4% they refer to is for Year 1 of retirement. From year 2 onwards, the 4% will increase slightly to account for inflation.
It is possible, but with proper planning this can be mitigated. If you have planned with very little margin for unforeseen events, then you need to periodically monitor your investment portfolios. If your investment is at risk and makes you run out of money sooner, then make changes to your lifestyle and look at earning additional income with a side job etc.
Of course you can, if you want a wider net and more safety. You can consider a SWR of 3%. To calculate with 3%, simply multiply your annual expense with 33 (3%) instead of 25 (4%).
This is the % of money you withdraw from you assets and investments year on year without exhausting your investments.
Well, the Trinity study that proposed the 4% withdrawal rate has taken market crashes into consideration. According to them, this will average out as decrease in stocks will be preceded or succeeded by a market boom. Additionally, I suggest you have course correction plans and also reduce your expenses or earn money on the side to compensate and balance this.