4% rule for early retirement is a ‘terrible idea’

If you’re hoping to retire early, you’ll have to find a way to replace your salary without working. Under a traditional model, that means accumulating enough savings that you can withdraw some every year to fund your lifestyle while the rest continues to grow.

Short of winning the Powerball, how much do you need to save? Adherents of the FIRE movement — short for financial independence, retire early — aim for a target of 25 times your annual income in retirement.

The figure, known as your “FIRE number,” is based on the idea that you can safely withdraw 4% of your portfolio per year, adjusted for inflation, without running out of money. This “4% rule” comes from a 1998 research report known as the “Trinity study,” which examined historical market performance to determine a safe withdrawal rate in retirement.

But here’s the thing: The numbers in the Trinity study were geared toward people looking for a traditional retirement in their mid-60s. When it comes to using it as the sole basis of your early retirement, experts are skeptical.

“I think it’s a terrible idea,” David Blanchett, managing director and head of retirement planning at PGIM, said at a recent seminar. “The 4% rule by definition is for a 30-year retirement horizon. You shouldn’t use it for 50 years.”

Consider smaller withdrawals for a longer retirement

It’s not as though proponents of early retirement are just misunderstanding the study. Although the Trinity study assumes a 30-year retirement, the compounding nature of investment returns means that the math can be applied over longer periods, experts say.

“When you actually look at the math and extend it out over a longer period, in most cases your money is going to triple or quadruple,” says Grant Sabatier, a leading figure in the FIRE movement and creator of the financial site Millennial Money. “That’s the nature of a compounding curve.”

But extending the length of your retirement widens the margin for error in your portfolio, experts say. That means it may be wise to aim for a slightly lower withdrawal rate the longer you plan for you money to last. Researchers at Morningstar say a safe withdrawal rate may lie somewhere between 3.3% and 4%, for instance.

“In general, if you have a portfolio balance and you’re planning to stretch your withdrawals out over 40 or 50 years, starting with a lower withdrawal rate gives you a higher probability of success,” Christine Benz, director of personal finance and retirement planning at Morningstar, told CNBC Make It.

Aiming for a lower withdrawal rate means you’ll need to save more money if you want to fund the same lifestyle. Under the 4% rule, multiplying your income by 25 really means dividing it by 0.04, so if you want to live off $40,000 in retirement, you’ll need $1 million. If you plan to withdraw 3.3% per year instead, your FIRE number jumps to $1.2 million.

Use the 4% rule with flexibility: ‘Life is life’

Even if adjusting your withdrawal expectations improves your odds, it’s still smart to avoid sticking hard and fast to mathematical rules when it comes to financing your retirement. After all, when has the rest of your life gone exactly according to plan?

“Research has demonstrated that a more dynamic approach to spending in retirement would be appropriate,” says Nilay Gandhi, senior wealth advisor at Vanguard. “Life is life.”

In other words, hitting your FIRE number doesn’t mean you can stop actively managing your financial life. Quite the opposite: Blindly withdrawing the same amount of money every year increases the chances that a down market could deplete your savings to the point where you run out of money.

Instead, retirees can take a “dynamic” approach to withdrawals by taking out more when the market is up and less during down markets.

That will take some planning ahead. Gandhi suggests any early retiree continuously review their goals and spending patterns, both before and during retirement. Having a budget that you understand and can actually follow will make it easier to make adjustments, he says.

It’s also essential that you plan for unexpected expenses, “such as an illness that comes up that’s not covered by certain types of insurance,” Gandhi says.

FIRE experts recommend building a robust cash reserve that can help shield you from having to withdraw money from a down portfolio. Sabatier keeps two years’ worth of expenses in cash as a “buffer” to ensure he doesn’t have to sell his investments for emergency cash during a market drawdown.

That way, he says, “I don’t have to make those snap decisions when the market is down.”

Want to earn more and work less? Register for the free CNBC Make It: Your Money virtual event on Dec. 13 at 12 pm ET to learn from money masters like Kevin O’Leary how you can increase your earning power.

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