For those of you without cushy pensions, I’m sorry folks. The 4 percent rule is outdated. It is now unwise to follow the 4 percent rule as a proper safe withdrawal rate in retirement.
The Federal Reserve and the Central Government have made reaching financial independence and living off only retirement income more difficult. We should consider following the 0.5 percent rule instead. Let me explain why.
After sending out my weekly newsletter saying we should all be thankful to the Federal Reserve for bailing us out, a number of readers sent angry responses. Here is one of the more lengthy ones.
The Fed is terrible.
They create debt, they print money, they weaken the dollar, and they create socialism. They also ensure there is an unhealthy power grab at the central government. We now accept that the central government is the babysitter, mother, and protector of us when we stub our toes financially, physically, or by other means such as a national disaster.
The Fed has NEVER been audited. I’m sure you know that. It’s also a private business made up of private bankers that control our money supply.
Need some QE? Here comes the Fed with their massive printing press and voila! We have more money in the system. Need to artificially support the stock market? Voila! Here comes the Fed with massive money pumping and now we have industries that are protected by US tax dollars.
So to me, this isn’t positive news because the elephant in the room needs to be fed. We are simply kicking that can down the road so we can continue buying all our toys, big homes, and make believe that everything the US government and the Fed are doing is good for us.
It’s only good for bankers. We are the sorry fools who have to pay the tax bill on 27 trillion in debt….and it’s still growing.
The Evil Fed And Government
The commenter has a point here. We will eventually have to pay back our debt in the form of higher taxes. Or we will have to eventually implement austerity measures to control our budget. Both are likely to happen. We just don’t know when. Perhaps our children and our grandchildren will foot the bill.
Let’s say we all agree that the Federal Reserve and the Central Government are terrible for Americans.
They shouldn’t have unleashed trillions in stimulus money to save us from another great depression. Maybe they should have let the stock market collapse and tens of millions of unemployed people go into financial ruin.
After all, a free market is a fundamental point of capitalism. Let’s just make sure that anybody complaining about the Fed and the central government give back their stimulus checks and enhanced unemployment benefits.
At the same time, all of us deserve to eventually retire and live a life with less financial stress. Nobody wants to work at a job they dislike until they die.
For those who haven’t been regularly investing, the Federal Reserve and the Central Government have turned the game of life on extreme hard mode.
The proper safe withdrawal rate has plummeted. Our government want us to work forever to fund their massive spending!
The Proper Safe Withdrawal Rate Has Changed
Due to a record amount of stimulus created in a record short amount of time, interest rates have dropped faster than a cement block tied to a dead body thrown off a boat in the middle of Lake Tahoe by one of Capone’s capos.
The 10-year bond yield is at ~0.7%. It will likely stay under 1% for years to come.
At a 0.7% risk-free rate of return, $1 million will only generate $7,000 a year in risk-free, pre-tax income.
If you’ve got your home paid off, your health insurance covered, and your kids all grown up and independent, $7,000 + Social Security will provide for a very simple retirement lifestyle.
Even if you got the maximum Social Security monthly payment of about $2,900 a month or $34,800 a year, you’ve only got $41,800 a year in income. You’re not popping Crystal off your yacht with only a $1 million net worth.
Unfortunately, the average Social Security payment is closer to $1,500 a month instead. Therefore, we’re really talking about an average annual Social Security benefit of $18,000.
Once you’ve reached financial independence or retirement, your risk profile goes way down. This is why using a safe withdrawal rate closer to a risk-free rate of return makes sense.
Besides, returns in the stock market, bond market, and real estate market are all relative to the risk-free rate of return. If the risk-free rate of return declines, so do overall returns for risk assets.
For example, a company looking to raise money to fund operations isn’t going to issue a bond that pays 8%, unless it’s in dire straits. Instead, a company will probably discover that adding a 2% – 3% interest rate premium to the 10-year bond yield will garner enough demand.
Using the 10-year bond yield as a barometer for retirement income generation is conservative. But I also believe the ideal withdrawal rate in retirement doesn’t touch principal so long as your estate is below the estate tax threshold.
If your estate is above $11.58 million per person, feel free to increase your withdrawal rate to whatever you want. Paying a 40% death tax rate on every dollar above the estate tax threshold is a crying shame.
Why The 4 Percent Rule Is Outdated
The 4 percent rule is based on the Trinity Study conducted by three Trinity University professors in 1998. Inflation and interest rates were much higher and pensions were common. The 4 percent rule is the most common safe retirement withdrawal rate cited.
Some like to naively claim that they are financially independent once they achieve a net worth equal to 25X their annual expenses. But if you think logically, there’s a big problem with the 4 percent rule.
Let’s look at where the 10-year bond yield was back when the Trinity Study was published in 1998.
In 1998, the 10-year bond yield was between 4.41% to 5.6%. Let’s say the average 10-year yield rate was 5% in 1998.
Therefore, of course you’d likely never run out of money in retirement following the 4 percent rule. Back then, you could earn 1 percent more on average risk-free!
See the historical chart of the 10-year bond yield below.
I really hope people who blindly follow the 4 percent rule or the 25X expenses rule realize this very important point. Everything is relative when it comes to finance. To use a rule today that was created when the 10-year bond yield was much higher is irresponsible.
20X Gross Income Net Worth Target
If you want to follow a more reasonable net worth target goal, then try to amass a net worth equal to 20X gross income. Only then, do I believe you might be able to declare yourself financially independent.
With my 20X gross income rule, you can’t cheat by simply lowering your annual expense budget. The 20X gross income rule forces you to accumulate more wealth as your income grows. It also makes you better decide whether you want to continue your way of life.
That said, even the 20X gross income rule may still not be high enough if you want to ensure that you don’t run out of money in retirement.
The New Safe Withdrawal Rate To Follow: 0.5 Percent
If you provide a similar 9% to 28% discount to the 10-year bond yield to come up with a safe withdrawal rate back in 1998, then the safe withdrawal rate in 2020+ is equal to 10-year bond yield X 72% – 90%.
In other words, the new safe withdrawal rate in 2020+ is even lower than just withdrawing based on the 10-year bond yield rate. And you thought my withdrawal rate was too conservative.
With the 10-year bond yield at ~0.7%, a safe withdrawal rate is actually closer to 0.5% – 0.63%. When the 10-year bond yield was at its low of 0.51%, the safe withdrawal rate was equivalent to 0.36% – 0.46%.
To make things simple, the new safe withdrawal rate equals the 10-year bond yield X 80%. We’ll use an average 20% discount to the 10-year bond yield to come up with the safe withdrawal rate.
The 20% can be viewed as a buffer in case of financial emergencies, bear markets, poor spending habits, and a further decline in interest rates.
Thanks to a steady decline in interest rates, 4 percent rule from 1998 has declined by over 85%. In other words, we should change the name of the 4 percent rule to the 0.5 percent rule.
The 0.5 percent rule is memorable and easy to follow. As a rational believer in the 0.5 percent rule, you have a desire to not run out of money in retirement and leave some of your wealth to your kids and various charitable institutions.
If you’re OK with spending all your money and leaving nothing, then the 20X gross income rule as a net worth target before retiring is probably good enough. If not, carry on reading.
Proper Safe Withdrawal Rates
To make things easy, I’ve put together the proper safe withdrawal rates in retirement. Given the 4 percent rule was established when the 10-year bond yield averaged 5 percent in 1998, we can multiply various 10-year bond yield rates by 80% to come up with an appropriate safe withdrawal rate.
The 0.5 Percent Rule Is The Reality
Although the 0.5 percent rule may sound extreme, it is based on financial reality today. 2020+ is a very different time than 1998. Inflation is much lower and risk asset returns will likely be structurally lower for a while as well.
We can certainly take more risk by investing in riskier assets with higher potential yields. However, once again, if you are close to financially independent or financially independent, you should invest more conservatively. Going financially backwards is terrible because time is so precious.
Thankfully, none of us are zombies. We don’t aimlessly follow a safe withdrawal rate rule until we die. Instead, we adjust based on economic conditions.
If we feel more risk-averse, we will lower our withdrawal rate below the 0.5 percent rule, save more money, or figure out ways to make more money. If we feel like sticking our heads in the sand and ignoring logic, we can stick to a 4 percent or higher withdrawal rate. We can also choose to work for life.
There is not a better chart that shows we can change if we want to change than the chart below. All it took was a global pandemic for the typical American to finally save over 30%! We are adaptable.
The 0.5 Percent Rule Provides A Net Worth Stretch Target
With the 4 percent rule, you multiply your annual expenses by 25 to get a target net worth. With the 0.5 percent rule, you multiply your annual expenses by 200 to get a target net worth.
Following the 0.5 percent rule to obtain financial independence is difficult. For example, I’ve challenged myself to generate $300,000 a year in passive income. The goal of $300,000 has been carefully calculated to pay for between $150,000 – $200,000 a year in after-tax expenses.
Therefore, in order to proclaim true financial independence using the 0.5 percent rule, I would need to amass a net worth of between $30 – $40 million.
As two unemployed parents, amassing a $30 – $40 million net worth appears next to mission impossible. We’ve only got Financial Samurai to help us generate active income at the moment. However, at least the 0.5 percent rule has provided a new net worth target to shoot for.
Now we’ve got to figure out whether it’s worth both of us trying to find day jobs again and not seeing our kids all day for the sake of more wealth. It might be worthwhile given there should be more work from home opportunities.
I suggest calculating your financial independence using the 0.5 percent rule as well. Divide your annual expenses by 0.5% percent to come up with your net worth stretch goal. Or multiply your desired annual expenses in retirement by 200 to get to the same amount.
Now that you have your net worth stretch goal, you will be more proactive in figuring out ways to accumulate more wealth.
Supplementary Retirement Income
If you find the 0.5 percent rule to be an impossible or ludicrous net worth goal, then all you’ve got to do is earn supplemental retirement income. Your supplemental retirement income fills in your income shortfall.
For example, let’s say you want to live off $100,000 a year in retirement income. This would equate to having a $20 million net worth using the 0.5 percent rule. Unfortunately, you’ve been blindly following the 4 percent safe withdrawal rule. Therefore, you thought accumulating $2.5 million was enough.
You now realize the 4 percent rule was developed in 1998 when the 10-year bond yield averaged 5%. After cursing out the Federal Reserve and the Central Government, you calm down and figure out the gap.
Your $2.5 million can only safely generate $12,500 a year in passive income using the 0.5 percent rule. Therefore, your retirement income shortfall is $87,500 ($100,000 desired retirement income – $12,500 your true retirement income).
Since you don’t think you’ll ever get to a $20 million net worth, you need to find a way to make $87,500 a year in supplemental retirement income. Thankfully, there are multiple ways to make money from home nowadays.
You can always try and live on less. Or you can do a combination of both. It’s up to you to decide what’s your ultimate combination.
Another Way To Use The 0.5 Percent Rule
A less onerous way to calculate your retirement net worth goal is to add up how much retirement income you already have and subtract it from your desired retirement income. Just know there is always a risk your existing retirement income may decline, especially with a decline in interest rates.
For example, my current retirement income is about $250,000 a year. My goal is to have retirement income of $300,000 a year. Therefore, I’m $50,000 short.
Using the 0.5 percent rule, I would need to amass another $10 million in net worth. $10 million comes from dividing $50,000 by 0.5 percent or multiplying $50,000 by 200.
Or, I can simply find a way to make an additional $50,000 a year in active income to live the life that I want. Ideally, you want to create active income after your career in an enjoyable way.
If it wasn’t for Financial Samurai, I would try to make at least $50,000 a year teaching tennis. If for some reason I couldn’t teach tennis, I’d self-publish another book or try and get a book deal with a traditional publisher. Tennis and writing are my two favorite hobbies.
Realistically, thanks to the dramatic decline in interest rates, the days of retiring and doing nothing all day are over. And this is not a bad thing. It’s great to stay active in retirement.
Your goal is to try and make income from things you enjoy doing. One of the key reasons why I’ve consistently published three new articles a week since 2009 is because it’s fun to help people see what’s financially possible.
If you find something you’d be willing to do for free, you’re going to have a wonderful post-career life. If not, your run the risk of running out of money and feeling empty in retirement.
Reach Your Target Net Worth And Then Choose Whatever Withdrawal Rate You Like
OK. Let’s say you still think a 0.5 percent withdrawal rate is absolutely unreasonable. You have the right to do nothing in retirement! Even if your net worth provided a 0% annual return, it would still take you 200 years to draw down your entire net worth at 0.5 percent. Given the median life expectancy is around 85 years old, 200 years is excessive.
Therefore, don’t use the 0.5 percent rule as a safe withdrawal rate. Use the rule only as a net worth target. Once you’ve reached your net worth target based on the 0.5 percent rule, then you can change your safe withdrawal rate as you see fit.
For example, let’s say you are happy living off $50,000 a year in retirement. You don’t have a pension or any passive income. The 0.5 percent rule says that you will need to amass a $10 million net worth. Let’s say you succeed in getting to $10 million by age 70 and expect to live until age 90.
With an expected 20 years left to live, you could divide your $10 million by 20 and safely withdraw $500,000 a year. Withdrawing $500,000 a year is equivalent to a 5 percent withdrawal rate. If there is a bear market or big unexpected expense during this time, you can adjust your withdrawal rate accordingly.
The 0.5 Percent Rule Is A Guide
As someone who left his day job in 2012 at 34, I’m simply providing you some firsthand retirement perspective. It is very easy to pontificate about the proper safe withdrawal rate in retirement while you are still working.
But I assure you, only when you and your partner no longer have a steady paycheck will you genuinely experience all the emotions that comes with being unemployed.
Until this day, I have yet to meet an early retiree who isn’t generating some sore of supplemental income. Some will end up generating a massive amount of supplemental retirement income. While some may just earn an extra few books here and there.
Once I left work, I challenged myself to not withdraw any money from my retirement accounts e.g. 0 percent withdrawal rate. Instead, my goal was to allow my retirement accounts to compound as much as possible during a bull market. Today, I’m trying to consumption smooth and spend more money on a better life.
Don’t be mad at the 0.5 percent rule. The 0.5 percent rule is just a net worth and safe withdrawal rate guide in this low-interest rate environment. Depending on how much of your wealth you want to pass on, the 0.5 percent rule may be too aggressive or too conservative. You only you can decide.
At the minimum, I hope most of you will at least agree that the 4 percent rule is obsolete. We don’t live in 1998 any more. Lower your safe withdrawal rate percentage or shoot for a higher net worth target before retiring. Alternatively, learn to live happily on less or find ways to make supplemental retirement income.
If interest rates dramatically increase or decrease, we can reconsider the 0.5 percent rule. But for now, the 0.5 percent rule is a more appropriate safe withdrawal rule to follow than the 4 percent rule.
Net Worth Management Suggestion
If plan to now boost your net worth further using the 0.5 percent rule, then I suggest tracking your finances for free with Personal Capital’s award-winning financial app. The more you can stay on top of your finances, the more you can optimize your wealth.
Readers, do you think the 4 percent rule is outdated? What do you think about my 0.5 percent rule as a safe withdrawal rate or as a way to calculate your target net worth? What do you think is the proper safe withdrawal rate in retirement?