Common investment advice for retirees often includes the 4% rule. Developed by William Bengen in 1994, the rule says a retiree with a 30-year time horizon could spend 4% of their portfolio the first year in retirement, followed by inflation-adjusted withdrawals in subsequent years.* This rule has even made its way into the FIRE movement and is the topic of our recent research paper, Fuel for the FIRE: Updating the 4% rule for early retirees.
FIRE stands for “Financial Independence Retire Early.” FIRE investors save as much of their income as possible during their working years, hoping to attain financial independence at a young age and maintain it through the rest of their life—aka retirement.
The 4% rule, which aims to help retirees find a safe withdrawal rate for each year in retirement, may be right for investors with a 30-year retirement horizon. But others, including FIRE investors whose retirement horizon could be 50 years or more, will have better odds of making their savings last by customizing the 4% rule using Vanguard’s principles of investing success.
1. Estimate future returns using forward-looking predictions.
The 4% rule was tested using historical market performance data from 1926 to 1992. Since it worked for that time period, some investors have assumed it will be successful in other time periods. That’s a big assumption (and one I wouldn’t be willing to bet my retirement success on).
Relying on past performance to predict future returns can make you too confident about your likelihood of success—especially now, when bond yields are historically low. Strategic market and economic forecasts are more likely to accurately predict what the future holds.
Vanguard uses the Vanguard Capital Markets Model® (VCMM), our financial simulation engine, to forecast future performance by analyzing historical data that drive asset returns. (Vanguard’s economic and market outlook research is updated regularly; it’s located on our Investment research & commentary page.)
We compared historical U.S. stock and bond returns between January 26, 1926, and March 31, 2021, with our 10-year VCMM median forecast for U.S. stock and bond returns. As the charts below show, historical returns were much higher than our current forecasted returns. Focusing only on historical returns could make investors overly optimistic about the future.
Historical returns are no guarantee of future returns
The VCMM forecasts are as of December 2020 and correspond to the distribution of 10,000 simulations for 10-year annualized returns for U.S. stocks and U.S. bonds. The median return is the 50th percentile of an asset class’s distribution of annual returns. The 10-year median forecasts for U.S. stocks, U.S. bonds, and inflation represent the annualized expectation over a 10-year horizon, though considerable uncertainty in those outcomes remains over the period.
IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of December 2020. Results from the model may vary with each use and over time. For more information, please see Notes at the end of the article.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
Notes: Data for average historical U.S. stock returns, U.S. bond returns, and inflation figures cover January 26, 1926, through March 31, 2021. U.S. stocks are represented by the Standard & Poor’s 90 Index from 1926 through March 3, 1957; the S&P 500 Index from March 4, 1957, through 1974; the Wilshire 5000 Index from 1975 through April 22, 2005; and the MSCI US Broad Market Index thereafter. Bonds are represented by the S&P High Grade Corporate Index from 1926 through 1968, the Citigroup High Grade Index from 1969 through 1972, the Bloomberg Barclays U.S. Long Credit AA Index from 1973 through 1975, and the Bloomberg Barclays U.S. Aggregate Bond Index thereafter.
Sources: Vanguard, from VCMM forecasts, and Thomson Reuters Datastream.
2. Use an appropriate retirement horizon.
The 4% rule is based on a 30-year retirement horizon. However, a FIRE investor’s retirement could last 50 years or more. That’s a big difference! According to our VCMM calculations, the 4% rule gives an investor with a 30-year retirement horizon about an 82% chance of success—but a FIRE investor with a 50-year retirement horizon only a 36% chance of success.**
Your time horizon is an important factor when defining your goals. We recommend calculating your withdrawal rate using a realistic retirement time frame.
3. Minimize costs.
It’s important to note that the 4% rule didn’t factor investment fees into estimated returns, which also affects its likelihood of success.
If we reevaluate a FIRE investor’s 36% chance of success by applying a 0.2% expense ratio to their portfolio, their estimated success rate drops to less than 28%. With a 1% expense ratio, that estimate drops to less than 9%.**
As the numbers show, minimizing costs allows for a significantly higher likelihood of success.
4. Invest in a diversified portfolio.
The 4% rule was calculated using only U.S. assets. Vanguard believes investing in a diversified portfolio increases your chances of success regardless of your anticipated retirement horizon or financial goal.
In our calculations, we assumed the FIRE investor’s portfolio contained only U.S. stocks and bonds. If that investor has a diversified portfolio with U.S. and international assets, their chance of success jumps from 36% to 56%.**
To get the full benefit of diversification, Vanguard recommends investing about 40% of your stock allocation in international stocks and about 30% of your bond allocation in international bonds. According to Vanguard research, almost 90% of your investment portfolio’s performance—in other words, if (and how much) your portfolio gains or loses—is the result of your asset mix.†
5. Use a dynamic spending strategy.
Once FIRE investors achieve financial independence, they have to spend strategically to maintain that independence over the long term.
The 4% rule uses a dollar-plus-inflation strategy. In your first year of retirement, you spend 4% of your savings. After your first year, you increase that amount annually by inflation. This approach allows you to calculate a stable, inflation-adjusted amount to withdraw each year.
However, this approach doesn’t take market performance into account. So when the markets perform poorly, you still increase your annual spending to offset inflation, which increases the chance of depleting your retirement savings. On the other hand, when the markets perform well, you don’t have the flexibility to raise your spending amount beyond the inflation increase to take advantage of excess returns.
Although every spending strategy has pros and cons, we recommend using a dynamic spending strategy. This approach allows you to spend more when markets perform well and cut spending when they don’t. To avoid big fluctuations in retirement income, you set a limited range for your income stream by defining a spending “ceiling” and a spending “floor.”
Giving yourself more spending flexibility may decrease your income stability, but it increases your long-term chance of success. Our research shows that when a FIRE investor with a 50-year retirement horizon uses a dynamic spending strategy, their probability of success in retirement increases from 56% to 90%.**
Creating a clear, appropriate investment goal is Vanguard’s first principle of investing success, and FIRE investors certainly have one: to achieve financial independence early and maintain it over the long term. Updating the 4% rule in accordance with Vanguard’s principles of investing success can help FIRE investors achieve that goal, giving them freedom to embark on their next adventure.
*Bengen, William P. 1994. Determining withdrawal rates using historical data. Journal of Financial Planning, 7(4), 171–180.
**We assume initial wealth at retirement of $1 million and a starting withdrawal of $40,000 (4%). In the 4% rule scenario, the investor withdraws inflation-adjusted amounts equal to 4% of the portfolio’s initial value. In the dynamic spending scenario, the investor initially withdraws 4% of the portfolio and adjusts the withdrawal amount according to market performance. The margins of adjustment are 5% (ceiling) and –1.5% (floor). The asset allocation is 30% U.S. equities, 20% international equities, 35% domestic fixed income, and 15% international fixed income. The retirement horizon is assumed to be 50 years. This calculation does not take into account the role of fees and taxes.
±Source: Vanguard, The Global Case for Strategic Asset Allocation (Daniel W. Wallick, et al., 2012).
All investing is subject to risk, including the possible loss of the money you invest. Past performance is no guarantee of future returns. Diversification does not ensure a profit or protect against a loss. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Advice services are provided by Vanguard Advisers, Inc., a registered investment advisor, or by Vanguard National Trust Company, a federally chartered, limited-purpose trust company.
IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.