The 4% rule can make you financially independent.

Navigating the vast world of retirement planning can often feel like charting a course through uncharted waters. The four percent rule guideline consistently attracts attention among the myriad strategies that financial planners support – for good reason. It has been tried and tested against the volatile returns of market history, guiding retirees towards a balanced and strategic withdrawal plan. Dive deep with me as we explore the math and foundation of this rule and how it can lead you to stable financial independence. Your journey towards a secure retirement can start here if you keep reading.

The 4% rule: definition and origin

The 4% rule, often called the Safe Withdrawal Rate (SWR), comes from a study conducted in the 1990s by financial planner William Bengen. The rule suggests that if you withdraw 4% of your pension savings in the first year and adjust that amount each subsequent year for inflation, your savings should last 30 years.

How it works

Let’s break this down with a simple example:

1. Imagine that you have a pension portfolio of SEK 10,000,000.

2. you would withdraw 4% of it in the first year of retirement, or $400,000.

3. Each subsequent year you would adjust $400,000 for inflation. For example, if inflation was 2%, you would withdraw SEK 408 000 the following year.

The study assumes a pension savings portfolio of 50% equities and 50% bonds.

The basis of the 4% rule is based on historical data on financial market developments, in particular in the United States. When William Bengen conducted his research that eventually led to the design of the 4% rule, he made certain assumptions about the composition of the retiree’s investment portfolio. Specifically, he looked at portfolios with 50% stocks and 50% bonds.

1. Balance growth and safety: A 50/50 split between equities and bonds balances the growth potential of equities with the relative safety and stability. Over the long term, stocks have historically provided higher returns than bonds, but they also come with higher volatility. Bonds, on the other hand, tend to offer more stable but lower returns.

2. Historical data: Bengen’s research considered the worst scenarios in market history. He wanted to set a withdrawal rate that would have worked even during the most challenging periods in the history of financial markets. With a 50/50 portfolio, Bengen ensured that even during prolonged stock market declines, the more stable bond component could provide a cushion.

3. Diversification: This mix diversifies the portfolio across different asset classes, spreading and potentially reducing risk. If one asset class performs poorly (e.g. stocks during a market downturn), the other asset class can provide some stability (e.g. bonds can maintain their value or not fall as much).

4. Rebalancing: With a 50/50 portfolio, retirees can regularly rebalance their investments. For example, if stocks perform exceptionally well in a given year and now represent 60% of the portfolio, the retiree can sell some stocks and buy bonds to return to the 50/50 allocation. This strategy ensures buying low and selling high to some extent.

However, it is important to note that even if the 4% rule was based on a 50% stock and 50% bond portfolio, it does not mean that such an allocation is optimal for everyone. Individual risk tolerance, financial needs, market conditions and retirement goals can all affect the ideal asset allocation for any person. As such, the 4% rule and its associated portfolio allocation should be used as a starting point or guideline, not an immutable rule.

How the 4% rule can guide you to achieve financial independence

1. Determine your annual spending needs: First, you need to know how much you expect to spend each year in retirement. Let’s say you decide that you need SEK 400 000 annually.

2. Calculate the capital required: To determine how much you need to save, divide your annual expenditure by 4%. In our example: SEK 400 000 divided by 0.04 = SEK 10 000 000. So you would need a portfolio of SEK 10 million to support an annual withdrawal of SEK 400,000 under the 4% rule.

3. Set savings and investment goals: Once you know your target portfolio size, you can work backwards to determine how much you need to save and invest each month, given an expected return on your investments.

4. Revise and adjust: The journey to financial independence is not set in stone. It is important to review your figures and adjust for changes in expenses, investment returns and other factors that may affect your financial needs or the growth of your portfolio.

Limitations and considerations

1. changed market conditions: the 4% rule is based on past market conditions. Future markets may not provide the same returns, especially given that in recent years interest rates have been historically low and have suddenly gone higher, potentially affecting bond returns and their pricing based on yield.

2. longevity: If you live longer than 30 years after retirement or retire early, you may need to consider a lower withdrawal rate to ensure your money lasts.

3. Flexibility: It is important to be flexible in your spending. In years when your portfolio underperforms, you might consider withdrawing less.

4. other sources of income: the rule does not take into account other sources of income such as pensions or part-time work after retirement. These can complement your withdrawals and reduce the burden on your portfolio.

Things to consider

– Safe withdrawal strategy: the 4% rule offers a plan to draw down pension savings without rapidly depleting the deposit.

– The basis of market history: Rooted in the historical performance of financial markets, this guideline provides retirees with a course that is tested against tough economic times.

– Balancing Act: The rule balances potential growth and investment security by recommending a 50/50 split between equities and fixed income.

– Diversified approach: An even split between stocks and bonds distributes risk, allowing for some safety during market volatility.

– Adaptability: While the 4% rule is a good starting point, individual circumstances and market conditions may require adjustments.

Conclusion

Understanding the principles of the 4% rule is crucial for those who aspire to financial independence. This guideline is about combining past market data with a balanced investment strategy, to ensure retirees have a chance to fight against market downturns and longevity. But while it establishes a robust framework, achieving true financial peace may require adapting the rule to individual nuances and the ever-changing financial landscape.

The 4% rule is a useful guideline for those who want to achieve financial independence. However, individual circumstances vary, and it is always recommended to consult with a certified financial planner to ensure that your retirement strategy is tailored to your unique needs.

About the Viking

With Viking’s signals, you have a good chance of finding the winners and selling in time. There are many securities. With Viking’s autopilots or tables, you can sort out the most interesting ETFs, stocks, options, warrants, funds, and so on.

Click here to see what Vikingen offers: Detailed comparison – Stock market program for those who want to become even richer (vikingen.se)