3 BIG Problems with the 4% Rule | F.I.R.E | Financial Independence Retire Early

In todays video I’m going to talk about why the 4% rule for retirement doesn’t necessarily work if you’re considering early retirement or are looking for F.I.R.E. (Financial Independence Retire Early). I was researching this myself as I wanted to get an idea of how much money I would need to have invested to retire early

I’ll be talking through 3 main risks, which I’ve taken from an informative research paper from Vanguard titled ‘Fuel for the F.I.R.E.: Updating the 4% rule for early retirees.’ I’ll include some illustrations and stats and facts around what the problem is with the 4% rule and also if there’s anything you can do to fix these issues. I have linked the Vanguard Research Paper below as it contains far more details and explains more risks than I can fit into this video.

Followers of the F.I.R.E. movement—Financial Independence Retire Early—have relied on the ‘4% rule’ to determine what they can withdraw from their portfolios in their early retirement. The rule was developed in 1994 by William Bengen.

‘To achieve early retirement, F.I.R.E. investors cut costs aggressively and save large percentages of their income. Their milestone for financial independence is a portfolio large enough to sustain their spending with inflation- adjusted withdrawals equal to 4% of the portfolio’s initial value—the so-called 4% rule.

The 4% rule can be a good start for retirees, but it most likely needs to be fine-tuned for the F.I.R.E. movement.’

Taken directly from the Vanguard Research Paper: https://personal.vanguard.com/pdf/ISG...

Problem 1 - Retirement Horizon

‘The 4% rule was calculated for an investor with a 30-year retirement horizon, not one who retires early. F.I.R.E. investors may be in retirement for up to 50 years.’

It may be an obvious point but if you are retired for more than 30 years you have a greater chance of your retirement pot running out. The probability of success of the 4% rule over different time horizons is illustrated in this forecast.


Problem 2 - Absence of investment Fees

‘Bengen (1994) assumes that investors’ returns are the same as those for the historical market indexes for stocks and bonds detailed in Ibbotson Associates’ Stocks, Bonds, Bills, and Inflation 1992 Yearbook.

But there are costs associated with investing, such as mutual fund expense ratios. One must take these costs into account to determine the probability of success of a portfolio in retirement, as they reduce investors’ net returns.

As fees compound over time the have a huge effect on the chance of a successful retirement as shown in the illustration.


Problem 3 Failure to Diversify

‘Diversification is a powerful strategy for managing portfolio risk. When calculating the safe withdrawal rates for retirees, however, Bengen considered only U.S. stock and bond allocations. International stocks and bonds are a source of additional diversification.

Vanguards research has shown that global diversification can reduce a portfolios volatility. Vanguard’s most recent 10-year capital market forecasts indicate that international stocks are likely to outperform U.S. stocks (DiCiurcio et al., 2020). Though as always this cannot be guaranteed.

Hopefully if you’re considering retiring early or F.I.R.E this video has shown you some of the limitations with the 4% rule and how they can be remedied.

TIMESTAMPS
00:00-01:43 Introduction 4% Rule
01:43-03:52 Problem 1
03:52-07:01 Problem 2
07:01-09:24 Problem 3
09:24-10:21 Retirement Outro

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DISCLAIMER

Any information given in this video is for entertainment purposes only, and does not act as legal or financial advice. Your financial decisions are your own responsibility, and if you do require advice please contact a qualified Financial Adviser or Financial Planner.