Fueling the FIRE movement: 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.

Updates to the 4% rule for FIRE investors

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.

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%.**

Success in retirement

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.