The 4% Rule – How to Find Your FIRE Number?

The 4% rule is well known among stock market investors aiming for financial independence.

But most people never heard of it or aren’t sure what it represents. And if you’re one of them, this post is for you.

Understanding the 4% Rule or SWR (safe withdrawal rate), starts at asking a simple question:

How far am I from Financial Independence?

Maybe you saw bloggers publish their progress to financial independence, such as “X% to FIRE”.

But how do we know that? How does everyone get to these numbers?

Specifically, X% of what? Million dollars? I don’t know… Maybe.

But how much money do you think you need to retire on?

The first step is to remember what financial independence represents. It’s the state in which a person has sufficient means without having to work.

Now, maybe you have a number in mind. However, if you think about the amount in cash, you’re probably wrong.¹ Let me explain why the million(s) might not be enough.

Your FIRE Number & Inflation

Let’s say you’re a 20 year old with million dollars in the bank, tax-free. You retire right there and right then.

You start enjoying life and spending the best days with your friends & family. You’re smart with your money and don’t overspend – never buying fancy cars or watches, both of which you don’t need. You also inherited a house suitable for a family, so you won’t spend on housing as well.

Life made.

But there is one thing that might and will end up making things a little bit harder. And it indeed seems just a little bit, usually 2-3% each year.

It’s called inflation – the crucial factor for a functional economy. I won’t go in the details, but Investopedia, Wikipedia, and this video may end up teaching you more about inflation than a paragraph would. I also have a post about it.

Fast forward when you’re 70… You’re most probably broke, unqualified, and with no pension (because you never worked). Things simply became too expensive for you to keep up over the decades. #life

To put it into perspective, if a 70 year old person had million dollars 50 years ago (in 1968) and just kept them in cash, today they would be worth around $135k (calculated using the CPI Inflation Calculator)! That means that the things that costed 1$ when he was 20, cost a bit more than 7$ today.

You don’t notice the consumer price index changing day by day, but decade by decade it becomes way more obvious.

And let me remind you that this is the best case scenario – when the million dollars aren’t touched at all. Pulling money for day to day expenses would deplete the fund even before mid-life crisis hits.

How to protect yourself from inflation?

There are two ways to protect against inflation:

Income
Investments

The first one is self explanatory.

People’s earning potential differs, but in most cases, it’s more than enough to live on. Having an income means that you will earn in line with inflation.

But employment is not an option for us, early retirement obsessed individuals. That brings us to:

Investing and your FIRE Number

Our investments are the only way we can make our money last. So, what to invest in?

There are two proven but not risk-free ways: the stock market and the real estate market. To learn more about investing, you can check out How to Start Investing and Become an Investor.

The bottom line is, if one understands these markets, he can have an idea about the expected yearly returns. For example, the annual returns average in the 5-15% range for both asset classes.

So, what does a 5-15% return mean?

It means that your wealth grows faster than inflation, even leaving you with money to spare.

Wait… That actually means that you could, theoretically, spend some percentage of your accumulated wealth and… Never run out of money?

Yes.

The 4% Rule

The 4% rule refers to the safe withdrawal rate. It represents the rate at which one can withdraw from his investment portfolio without ever running out of money.

So, why exactly 4% and where did this “rule” come from?

Well, it first appeared in the Trinity Study in Trinity University in San Antonio. In summary, the study backtested a 50/50 stock/bond portfolio against real market data. It proved that a portfolio will never be exhausted with a 4% annual withdrawal rate in any 30 year period starting from 1925.

So basically, the portfolio’s performance was tracked for every 30 year interval (1925 – 1955, 1926 – 1956, etc.). And regardless of the market’s performance, the portfolio is never depleted with annual withdrawal rate of 4%.

A few things about the study I find important:

In many cases the safe withdrawal rate was >4%, but there were no cases where 4% SWR failed.
The 4% amount is calculated from the initial value of the portfolio, not from the decreasing amounts after the withdrawals each year.
The initial 4% amount was adjusted for inflation each year, which means it increased with the consumer price index in the subsequent years.

Criticism of the 4% Rule

Of course, past performance doesn’t guarantee future results.

Actually, there are many subsequent studies that prove that 4% is almost enough (i.e. not 100%). Some test for wealth retention instead of staying above zero and others test for extended periods of time.

The paper Safe Withdrawal Rates: A Guide for Early Retirees was a particularly good read. I’d recommend it to anyone who wants to see the modern perspective.

In other words: there is already a lot of controversy and critique around the 4% rule.

That’s why I’m not saying that the 4% rule is “perfect”, written in stone, or should be taken for granted. However, I am saying that it’s a fair measure of how much an early retiree would need until he reaches traditional retirement. And of course, it differs based on one’s personal situation, lifestyle, age, spending habits, etc.

For example, a 50 year old and a 30 year old will have a significantly different plans for early retirement.

Also, the 4% rule is a classic, so anyone even remotely considering FIRE should be aware of it.

One thing that most studies assume, and rightfully so because it’d be unscientific otherwise, is that all your income will be generated by market returns. However, in real life you may have some extra income, undertake any venture you’ll find appealing, inherit assets, go into real estate (as mentioned above), etc.

And hey, if something unexpected happens, you can always adjust your spending. Alternatively, you can sell assets for extra income, or, simply, go back to work.

Your FIRE number

So, how to calculate your FIRE number?

Well, you learned that you can estimate it using a 4% SWR from your investments every year.

That means that you should start by determining your yearly expenses. You can do this by estimating your monthly expense, add an overhead, and multiply it by 12.

Then, find the number of which 4% equals your annual spending. An easy way to do this is to take your annual spending and multiply it by 25.²

For example, if you live on $40k per year, you will need a million (40000 * 25) dollar portfolio to retire (early) on.

And here is where frugal life comes into play…

If you can live on $30k per year, you’d need $750k to retire. If you live on $20k, you’ll need $500k. And if you live on $0, you will need $0.

So, what’s your FIRE number?

To learn how to invest in the stock market the right way, check out the following resources: