There is no one right way to retire early. Some people have successfully sold their businesses for huge sums of money, while others have built a passive income stream that allows them to leave their 9-to-5 jobs.
Many proponents of the FIRE movement (short for financial independence, early retirement) aim to save a large portion of their income in order to build an investment portfolio large enough to permanently withdraw from it.
Whether you’re hoping to follow this model or are aiming for a traditional retirement, new research shows you may be able to get more out of your portfolio each year, or build smaller assets overall, than previously thought.
For years, financial planners and early retirees alike have relied on the so-called “4% rule” as a guideline. The rule, which says it’s generally safe to withdraw an inflation-adjusted 4% of a balanced portfolio each year after 30 years of retirement, was first described by financial advisor Bill Bengen in a 1994 paper published in the Journal of Financial Planning.
Bengen’s new book expands on his original research and, as a result, revise the safe withdrawal rate upwards. For those who are still planning to take 4% of their portfolio down in retirement, “I think they’re fooling themselves a little bit,” he told CNBC Make It.
Bengen’s default safe withdrawal rate after 30 years of retirement is 4.7%. And during periods of low to moderate inflation, that number could rise even more, even for early retirees, he says.
Reaching the 4.7% rule
Bengen arrived at that estimate by looking back at data as far back as 1926. Essentially, he says, he wanted to find out what percentage of a retiree’s portfolio could historically be withdrawn each year without anyone in the data set running out of money.
Back in 1994, Bengen made several assumptions. He assumed that historical investors saved 60% in large U.S. company stocks and 40% in intermediate-term U.S. Treasuries in tax-advantaged retirement accounts. He assumed that investors rebalance these allocations once a year. And he assumed that investors would withdraw a certain percentage at the beginning of retirement and then adjust the amount withdrawn for inflation the following year, similar to what Social Security does.
Putting these assumptions to work, we find that with an initial withdrawal rate of 4.1%, adjusted for subsequent inflation, no historical investor would run out of money after 30 years of retirement. This is how the “4% rule” was born.
Bengen made several adjustments to the latest research to better reflect the mix of assets investors hold for retirement. He currently envisions a portfolio of 55% stocks, 45% bonds and 5% cash in the form of Treasury bills. Its equity allocation includes U.S. stocks from large, mid-market, small and micro companies, as well as international exposure.
The result: In the worst-case scenario in history (high inflation and an unfavorable stock market), investors can safely withdraw 4.7% in retirement without running out of money for 30 years. If you’ve been retired for 50 years, that rate is closer to 4.2%.
Depending on the state of the economy and stock market at the time of retirement, you may be able to make even safer withdrawals, Bengen says.
Mr. Bengen said individual numbers can be high during periods when stock prices are not as highly valued or when inflation is at low to moderate levels. But be careful. During periods of bear markets or high inflation, especially early in retirement, you may be forced to make more modest withdrawals or increase the risk of running out of money, Bengen says.
“My research shows that if you endure a significant bear market early in retirement, your withdrawal rate decreases because you’re drawing more out of your portfolio at the same time you’re sucking more out of it,” Bengen says.
Inflation rates can also play a role in determining the amount to withdraw. Bengen says rapidly rising costs can deplete the purchasing power of your savings, forcing you to withdraw more money, cut back on spending, or both in retirement.
Bengen says no investor’s exit strategy is exactly the same, and it can be difficult to constantly monitor these factors. For these reasons, it would be wise to discuss your retirement plans, early or otherwise, with a financial professional.
And no matter what type of retirement you’re planning, Bengen says it’s wise to err on the side of conservative planning.
“You don’t know what the market is going to do, you don’t know what inflation is going to do. You don’t know how long you’re going to live.[You]have no idea what your expenses will be in 30 years,” he says.
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