The Real Problems with Using the 4% Rule to FIRE

Shortly after our July 9 post encouraging retirees to consider shoring up their floor portfolios by establishing budget buckets of low-risk investments to fund their future essential expenses, Michael Kitces released “The Problem With FIREing AT 4% And The Need For Flexible Spending Rules” aimed at very early retirees (Financially Independent/Retire Early individuals, or FI’ers).   His post discussed “safe” withdrawal approaches based on the 4% rule.  This rule of thumb anticipates at least 60% investment in equities, and, when assets are equal to 25 times expected annual expenses, may indicate when assets for an individual with a thirty year lifetime planning period are sufficient to retire (1/.04 = 25 times expected expenses).
 
Mr. Kitces uses historical investment return experience to argue that there is very little risk involved in investing 60%-80% in equities provided retiree withdrawals are set at “reasonable” levels.  For FI’ers with 50-year lifetime planning periods, Mr. Kitces recommends a 3.3%-3.5% initial withdrawal rate with inflation increases thereafter.  In terms of assets necessary to retire, this translates “conservatively” to about 30 times expected expenses according to Mr. Kitces.

In this post, we will slightly modify the hypothetical expenses shown in Mr. Kitces’ Annual Household Budget chart to make them a little more realistic for a 45-year old single male FI’er, and we will use that modified expense data to compare the spending and broad investment strategies developed under the Actuarial Approach (using default assumptions) with those that might be developed by Mr. Kitces.  If you aren’t interested in all the numbers, you can skip to the bottom line below.  In summary, while the two approaches produce comparable amounts of assets necessary to FIRE for our hypothetical FI’er, using the 4% Rule (as may be modified as suggested by Mr. Kitces) still has other potential problems, including:

• It doesn’t consider all sources of income or non-recurring expenses
• It anticipates at least 60% investment in equities
• It is a “set-and-forget” strategy that doesn’t automatically adjust for favorable or unfavorable experience (and therefore lifetime spending is overly dependent on the size of assets at retirement)
• It needs to be adjusted for different lifetime planning periods

Hypothetical Expense Data
 
So that you don’t have to keep flipping back to Mr. Kitces’ post, here is his table of Annual Household Budget with Line-By-Line Segmentation of Core vs. Adaptive for a hypothetical retiree.

	Core	Adaptive	Total
Housing	$25,000	$5,000	$30,000
Food	4,800	3,600	8,400
Clothing	2,000	1,000	3,000
Healthcare	12,000	0	12,000
Transportation	2,000	2,800	4,800
Entertainment	3,600	2,400	6,000
Travel	2,000	4,000	6,000
Charity	1,000	2,000	3,000
Other	2000	4,000	6,000
Total	$54,400	$24,800	$79,200

Because we encourage you to separate non-recurring expenses from recurring expenses when you are budgeting your spending, we are going to change two of the above expense items for our hypothetical 45-year old male FI’er and add a few other possible expenses.  We will also consider our FI’ers expected Social Security benefit.

1. Since our hypothetical FI’er will be eligible for Medicare at age 65 under current law, we will assume that his recurring (for life) annual healthcare cost will start at $6,000 and he will have an additional non-recurring annual healthcare cost until he reaches age 65 of $6,000 per annum. We will assume that his annual healthcare cost increases at 3% oer annum (assumed inflation plus 1%).  We agreed with Mr. Kitces that healthcare costs are probably 100% essential (or core).
2. We think Mr. Kitces’ estimation of travel costs was a little light for a 45-year-old retiree, and we also think that travel costs can be considered as non-recurring rather than as recurring expense for life.  Therefore, we assumed annual travel costs of $10,000 in real dollars, but ceasing when he reaches age 80.  We accepted Mr. Kitces’ 1/3rd /2/3rds split between essential and discretionary for this item. 
3. We think our FI’er had better plan to fund his taxes as recurring expenses (100% essential), so we added assumed taxes of $15,000 per annum.
4. We think our FI’er is going to need a new (or at least new to him) car periodically starting in about five years, so we budgeted a present value of $32,400 for this expense item.
5. We also budgeted future long-term care costs with a present value of $50,000 (50% essential), future unexpected expenses of $25,000 (100% essential) and future funeral expenses of $20,000 (0% essential) in today’s dollars.
6. On the income side, we assumed our FI’er would be eligible to receive an annual Social Security benefit of about $35,000 (in future dollars) commencing at age 67.

The non-recurring items in 2, 3 and 4 above added $398,508 to the present value of our FI’er expected expenses with about 50% of those expenses considered as essential.  The modified recurring annual expenses were:

1. Non-health:  $55,400, assumed to increase by assumed inflation of 2% per annum
2. Health:  $6,000, assumed to increase by 3% per annum, and
3. Discretionary:  $20,800, assume to increase by 1% per annum

Results

Using, our Actuarial Budget Calculator (ABC) for Single Retirees, we estimated that it would take accumulated savings of about $2,800,000 plus the present value of our FI’er’s estimated Social Security benefit ($322,088) to cover our FI’er’s estimated future recurring and non-recurring expenses, leaving about $58,000 as an unallocated reserve or rainy-day fund.  
The table below shows a screen shot of the Asset Reserve by Expense Type tab for our hypothetical FI’er. 

(click to enlarge)

Note that this screen shot shows the present value of essential expenses of $2,278,051 represents about 73% of the total present value of our FI’ers total assets (accumulated savings of $2,800,000 plus the present value of his projected Social Security benefit of $322,088)).  Building a floor of non-risky assets to fund these essential assets would therefore require about $1,955,963 ($2,278,051 – the present value of Social Security of $322,088) of our FI’ers accumulated savings (or almost 70%) to be invested in non-risky assets.  This is inconsistent with the 4% Rule principle to invest at least 60% of accumulated savings in equities.
 
By comparison, using Mr. Kitces’ suggestion that it is safe to FIRE when accumulated savings is equal to 30 times core (essential) expenses (based on a 3.3% Rule) plus 25 times adaptive (discretionary) expenses (based on the 4% Rule) would require accumulated savings in this example of $2,362,000 (30 X $61,400 plus 25 X $20,800).   However, this total would ignore expected non-recurring expenses, expected long-term costs and a rainy-day reserve fund with a total present value of in excess of $500,000, so in total we are talking about the same level of required assets to FIRE for this example 45-year old as developed under the Actuarial Approach. 
 
Mr. Kitces’ post notes that amounts necessary to FIRE may be reduced by anticipated post-FIRE employment income or by other sources of income.  Clearly, this is something that can be easily factored into the Actuarial Approach calculations.   We also note that the Actuarial Approach is simply much more mathematically rigorous than the 4% Rule of Thumb and, with its annual valuation process, can easily provide the “needed” spending flexibility called for by Mr. Kitces. 
 
Bottom line—As long as you are not ignoring your future non-recurring expenses or core expenses (like your taxes) and you don’t have other significant sources of income, using the 4% Rule (as may need to be modified for different expected lifetime planning periods) may not be all that bad for helping you determine if you have enough to retire.  We would caution you, however, to be skeptical of the 4% Rule requirement to be at least 60% invested in equities.  Instead we ask you to consider developing a floor portfolio of less risky assets to cover your essential expenses.  We also caution you to be skeptical of the “set and forget” process anticipated under the 4% Rule.  Instead, we encourage you to revisit your situation at least once a year and make adjustments when necessary. 
 
As noted many times in our blogposts, we are not investment advisors.   We won’t tell you how to invest your assets.   Mr. Kitces’ charts make a very seductive argument that if the future is like the past, there is a high probability that you will end your retirement with more money than you started with if you use the 4% Rule (as may be modified for early retirement) and invest significantly in equities.   Note, however, that investment in equities is not without its risks, especially in today’s investment environment.  As our friend Dirk Cotton said earlier this year, “The correct balance [between floor and upside portfolios] will depend on how willing you are to risk losing your standard of living for the chance of having an even higher one.”  If you are more concerned about losing your standard of living than having an even higher one, and you want to quit the “game” as a winner, you may wish to use our workbooks to determine your annual spending budget and to reduce your investment risk.