Rethinking the 4% Rule: Embracing the Flexibility of Early Retirement

Now that we understand the 4% rule–the rule that says you can safely pull 4% of your portfolio each year, adjusted for inflation after the first year–it’s time to add some nuance.  Many prominent early retirees–such as Mr. Money Mustache and the Madfientist–actually believe that the 4% rule is too conservative, leaving many people to stay at their corporate jobs for too long striving for a retirement number that is too large.  

Let us be clear, it’s not that we think the 4% rule is faulty or even flawed. Our gripe is with the assumption that it’s the golden rule for early retirement. See, this rule was designed with a traditional retirement in mind, where retirees are more likely to have rigid expenses and limited flexibility. But for those of us looking to step away from the corporate world in our 30s or 40s, it’s a different ball game altogether.

Early retirees enjoy a unique advantage—their flexibility. Unlike traditional retirees in their 60s or 70s, those retiring in their 30s or 40s have greater adaptability in their lifestyles and spending. They possess the ability to adjust their expenses, explore part-time or full-time work if necessary, and choose cost-effective yet enjoyable locations to reside. These factors result in a higher proportion of discretionary spending, which the 4% rule fails to consider. In fact, many now believe that a higher initial withdrawal rate, such as 5.5%, may be feasible and indeed more appropriately risk calibrated for early retirees.

However, that increased withdrawal rate is only as safe as 4% if you account for the increased flexibility of early retirement.  The way we do so is by determining what percentage of our spending is discretionary spending i.e., what we could potentially live without if we needed to, and adjusting our withdrawal amount based on how the market is doing that year.  Let’s look at a concrete example of how this would work.

Suppose a retiree has a portfolio of $1 million in an 80/20 stock/bond allocation. According to the 4% rule, the initial annual withdrawal would be $40,000, adjusted for inflation each year thereafter. However, with the discretionary spending approach, a withdrawal rate of 5.5% becomes viable.

Under this approach, the retiree allocates 50% of their spending to essential expenses and 50% to discretionary expenses. In year one, they withdraw $27,500 for essential spending (50% of 5.5%) and adjust their discretionary spending based on the market performance:

• If the market is less than 10% below its highs, they withdraw $27,500 for discretionary expenses.
• If the market is between 10% and 20% below its highs, they withdraw $13,750 for discretionary expenses.
• If the market is more than 20% below its highs (bear market), they suspend discretionary withdrawals.

In this example, using historical data from 1926 to 2022, the discretionary spending approach maintains a 98.28% probability of success over 40-year periods.

So, you’ve got more flexibility and potentially more money to spend in your retirement, or, like us, you could use this approach to step into retirement a few years ahead of schedule.  In this example, the early retiree would need to save $727,273 to withdraw the same $40k for expenses. It sounds pretty good, right? But remember, it comes with a caveat: you’ll need to be disciplined and willing to adjust your lifestyle according to market conditions. 

Remember, you will be able to see any errors in your calculations years before you run out of money, so you will have time to make adjustments. And as we talked about earlier, our conception of retirement does not involve lazing around on the couch, but instead pursuing passions that will, in all likelihood, probably lead to some income down the line.  

We’ll delve deeper into this strategy and others, but for now, we hope this post has sparked some thoughts about how flexibility can be incorporated into your plans. For more on the topic, check out the madfientist’s excellent deep dive.