Can The 4% Rule Actually Work For Early Retirement?

The 4% rule suggests that a retiree who withdraws no more than 4% of their portfolio each year could have provided for a 30-year retirement window during most historical retirement windows. And that is true! The problem is that the FIRE community, however, perpetuates at least two misconceptions when discussing the 4% rule. Today, we address those common misconceptions about utilizing investment income. And, most importantly, we discuss how to use a flexible withdrawal strategy to weather bear markets and/or reduced future returns.

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Misconceptions About the 4% Rule

1. Folks extend the 30-year retirement window to much longer retirement horizons, up to 60-70 years! While it’s true that the asymptotic relationship of withdrawal rates doesn’t change the outcome substantially, it is risky to extend the 4% withdrawal rate to retirement horizons greater than 30 years. Model it yourself here.

2. Investors believe that they should withdraw 4% of their portfolio each year. In a raging bull market, like the one in our rear-view mirror, this sounds great. If my portfolio grows 30% in a year, I can increase my spending by 30%! Alternatively, however, if my portfolio falls by 30%, we must cut our spending in stride. While many FIRE adherents shrug this off and claim they are “flexible,” I suspect that few are flexible enough to weather reduced share values for many years or even decades!

Actually, let’s talk more about flexibility.

The Realities of Long Bear Markets and the 4% Rule

When my wife and I began sharing our ambitions for financial independence, and particularly when I began to relate that I might quit my job, I was asked some variation of a common question.

Sure, I can see making money in the stock market. But what about when the market inevitably falls and you’ve already quit your job?

This is a surprisingly great question. It’s also a question that FIRE enthusiasts often shrug off as some sort of non-concern. When asked, many will simply point to the 4% rule as defined by the Trinity Study; a study most accept as gospel.

So long as I only spend 4% of my portfolio each year, I can’t run out of money.

This statement is piled high with assumptions. What asset allocation do you have? How long is your retirement horizon? How much spending flexibility do you really have? Could you be flexible potentially for decades? Can you really go back to work once your skills are eight years dated in a rapidly-evolving workplace? How is your timing (i.e., luck)? Are you retiring at the start or end of a bull market? All of this matters tremendously.

Recency Bias

Many have rightfully pointed out the glaring recency bias of what became the Great Bull Market, which lasted from the end of the Great Recession until 2020, but kind of kicked back up again through late 2021. We’ve all been conditioned by the last 11-12 years to expect not only positive market returns, but consistently positive returns. Since 2008, the S&P 500 has provided 11 out of 13 years of positive returns, with negative yearly returns only observed in 2015 and 2018. Barring a Christmas miracle, 2022 will be the third (and most prominent) year of negative returns. 

Fixed Withdrawals: Down Market = Down Spending

So, if the salad days of the last bull market are behind us, how can retirees react to reduced market returns? Let’s say a family with a yearly spending of $40,000 retired on December 31, 2021 with a portfolio of $1,000,000 and with an asset allocation of 100% VTSAX (100% stocks). Their spending/portfolio ratio indeed satisfies the 4% rule, or at least it did. At the time of writing, their portfolio is worth $750,000, as VTSAX is down approximately 25% year to date.

For this family to not over-withdraw, thereby greatly risking their portfolio longevity, they must cut their spending in stride, by 25%. To satisfy the 4% rule, they can now only spend $30,000 per year. If the market continues falling, let’s say to 50% of its previous high, these 4% rule adherents must cut their spending further, to $20,000. This could last for years.

How Flexible Can We Be?

Some say they can uproot their life and use the power of geoarbitrage to move to a town or even country with a lower cost of living. Let’s examine the utility of this statement. Sure, I suppose I could imagine myself living in Ecuador or Thailand for a year or two, waiting on a short-lived bear market.

Here’s the big hole with this logic: Many bear markets are not short-lived. This is especially true if we consider the time it takes to regain previous market highs. If someone moved to Ecuador in 2000 to reduce their cost of living, they wouldn’t have returned until almost 2016!

As Karsten at Early Retirement Now has pointed out, a retiree who pulled the plug in 1966 would have waited 28 (!) years to regain previous highs after years of shellacking in the 70s and early 80s. For 11 of those years, withdrawals would have been 40% or more below the initial spending level.

This dilemma is complicated further still by someone engaging in unsustainable frugality. It’s one thing to think you may never want a house/child/car/pesto in your twenties, thereby building a portfolio based on a low spending assumption. It’s another matter to wake up five or ten years later, resentful of a spending ceiling created by a younger version of yourself. And years down the road any marketable skills might now be quite stale. So, the common refrain of “I’ll just go back to work,” might not be exactly cut-and-dry.

How flexible can we be?

Sustaining a Portfolio in a Bear Market

The solutions for the dilemma of reduced returns (i.e., a reduced portfolio) are varied, and I’ll quickly address a few.

1. Save more, which allows for a lower withdrawal rate. For those serious about true early retirement with long horizons (30+ years), I’d recommend an initial withdrawal rate in the range of 3.25% – 3.5%. This was our approach.

2. Have spending flexibility. Don’t retire on a minimalist spending profile. I know it’s tempting to “get there” as fast as possible, but the grass is always greener on the other side.

3. Don’t really retire. Keep supplemental income through a passion project, part-time work, rental income, etc. We do this too.

4. Utilize a flexible withdrawal rate that acknowledges expected market returns. What!? Who can predict future market returns?

Enter the CAPE ratio…

The Flexible CAPE Ratio Withdrawal Strategy

The CAPE ratio, created by the American economist Robert Shiller, was developed as a backward-looking evaluation using real earnings per share (EPS) to smooth out fluctuations in corporate profits of a moving 10-year period.

The CAPE ratio, or cyclically adjusted price-to-earnings ratio, is generally applied to broad equity indices (i.e., the S&P 500) to evaluate whether the market is overvalued or undervalued. We can compare the current market price to its inflation-adjusted historical earnings, which is surprisingly effective in predicting broad, long-term (10+ year) equity evaluation outlooks.

CAPE Ratio = (share price) / 10-year average, inflation-adjusted earnings

In case your eyeballs are now bleeding, let’s talk in layman’s terms. The larger the CAPE ratio, the more we should (perhaps) be concerned about future market returns.

See Robert Shiller’s dynamic CAPE ratio and other data here.

What Is a “Good” CAPE Ratio?

For a sense of scale, the historical average of the CAPE ratio is between 15-16. Today’s CAPE ratio is 28, down from almost 40 at the S&P 500 peak back in late 2021. As such, someone who retires with an elevated CAPE ratio (>20) should be wary of their withdrawal rate. In fact, as Karsten at Early Retirement Now has pointed out, all failures of the 4% rule occurred when the CAPE was above 20! In general, higher CAPE values imply lower than average long-term annual market returns.

The last time the CAPE ratio sat reliably below 20 was way back in 2009. The S&P was then beginning its relentless climb from the hole of the 2008 financial crisis. Indeed, someone who was able to retire at that time enjoyed some really great years from a sequence of returns standpoint, just as suggested by the CAPE ratio at the time.

For more on the basics of the CAPE ratio, I’d suggest this post from Investopedia.

Let’s do a brief tangent:

Sequence of Returns Risk

When I left my job in early 2020, I chewed my nails a bit. I stared at the clouds, thinking of a CAPE ratio of ~30. Well, that and the fact that the stock market was tanking before my very eyes: The S&P 500 fell 30% in about a month! I wondered if I’d enjoyed very fortunate timing as an investor—locking in year after year of 10%+ returns—only to now be very unlucky; to pull the plug on the corporate world and have the stock market erode my nest egg during my most vulnerable period as an “early retiree.”

Being Mindful of the Early Years

Generally speaking, the first ten years or so are our most vulnerable in retirement. Over-withdrawing on a portfolio—whether due to market losses or just generally having no clue—during the first ten years can greatly increase the chances of premature asset depletion. This is otherwise known as a sequence of returns risk.

On a more positive note, alternatively, market gains that allow for low withdrawal percentages can greatly increase the chance that we will leave this earth with many multiples of our initial retirement portfolio. Instead of worrying about running out of money, you might be worrying about how to best use so much money!

Conservative Fixed Withdrawal Rates

Maybe it’s our own scarcity mindset around money, but my wife and I have always held an admittedly pessimistic belief around future returns. This is partially due to the CAPE ratio, which as mentioned above, has been elevated for the last 12+ years. As such we saw the coveted 4% rule as a bare bones initial withdrawal rate. We aimed for an initial withdrawal rate of 3.25%. We built in a lot of spending flexibility, as well as plans to immediately begin generating income. After about 16 months away from her job, my wife happily returned to part-time work.

Overkill? Probably. But YOLO. And we didn’t want to eat cat food one day.

Flexible Withdrawal Rates

Over time I’ve become more interested in a flexible CAPE-based withdrawal strategy. Despite all the seemingly pessimistic negative-Nancy talk above, this strategy actually allows for higher percentage withdrawals in bear markets. Why? The CAPE-based approach accounts for undervalued equities primed for growth; using evolving market fundamentals instead of a fixed withdrawal amount. Our purchasing power in bear markets might actually be higher than we think.

In other words:

1. The 4% rule is likely too aggressive in overvalued markets (CAPE > 20). This is especially true when the S&P 500 is at all-time highs (i.e., late 2021). According to Early Retirement Now, most modeled failures of the 4% rule occur when CAPE > 20.
2. Alternatively, in depressed market conditions (where the CAPE ratio falls below 20) the 4% rule is likely too conservative! A retiree may be cutting his or her spending unnecessarily. Strictly adhering to the 4% rule (or any flat rate), a 50% drop in the S&P 500 would require a 50% cut in spending. Oooof! Using a flexible CAPE-based strategy, however, the retiree may be able to temporarily withdraw a significantly higher percentage of their portfolio, say at 4.5% or even 5%+!. Spending, therefore, might only need to drop by 25% – 30%. With this strategy, we are able to account for above-average market returns that may soon sprout from the scorched earth of a bear market.

The CAPE-Based Withdrawal Calculation

Here is the equation we can use to create a variable withdrawal rate using the CAPE Ratio:

Safe Withdrawal Rate (SWR) = a + (b x (1 / CAPE))

Where a is the intercept of 1.75 and b is the multiplier of 0.5.

It’s true that the variables a and b can vary. Using values of 1.75 and 0.5, respectively, are shown to be a relatively conservative assumption in an already conservative approach. Good enough for me.

So, with the equation below we can do some math!

SWR = 1.75% + (0.5*(1/28))

SWR = 3.54%

Ouch, dude! I thought you said using the CAPE-based withdrawal method would allow for higher percentage withdrawals?! Adherents of the 4% rule won’t be pleased to hear that the CAPE-based future return predictions would suggest a withdrawal of no higher than 3.54%, even in a bear market. Back in late 2021, when the CAPE ratio was at ~40, that would suggest a SWR of no more than a measly 3%!

Adjusting the CAPE Ratio

One common complaint about the CAPE ratio is that it’s been “artificially” elevated for years and is no longer as relevant today. In recent decades, a lot has changed regarding corporate tax environments, dividend payout structures, and even stock buyback programs, all of which can affect earnings per share. As such, this has resulted in a CAPE ratio that is arguably overly pessimistic.

Just last week, Karsten over at Early Retirement Now suggested his proposal for Building a Better CAPE Ratio. The issue is partly one of timeliness; earnings data used to calculate the CAPE ratio by Shiller here is often lagging by at least three months. Karsten made several other modifications (accounting for corporate tax rates, stock buybacks, etc) described in great detail at the above-linked post to create a more optimistic (realistic?) CAPE ratio, provided in this Google Sheet.  

With Karsten’s calculations, today’s modified CAPE ratio is 20.9, down from the Shiller CAPE of 28 discussed above. According to these modified figures, the market is barely overvalued. Now we can calculate today’s safe withdrawal rate, which accounts for these dynamic market conditions:

SWR = 1.75% + (0.5*(1/CAPE))

SWR = 1.75% + (0.5*(1/20.9))

SWR = 4.14%

A 4%+ withdrawal rate is safe in this bear market

In this current depressed market, a 4+% withdrawal rate is indeed temporarily safe for an extended retirement horizon of 60 years. Unfortunately, however, even with ERN’s more optimistic calculations, a SWR of 3.39% was the ceiling back in late 2021. An early retiree who retired in late 2021 and immediately started pulling 4% from their portfolio is already off to a less-than-encouraging start for a long retirement horizon. As such, a high CAPE environment suggests lower initial withdrawal rates (<3.5%). Yes, the significant digits are indeed significant.

Today’s CAPE-based rate of 4.14% provides a withdrawal sum that exceeds our yearly spending, so we’re still in good shape. As a side note, when we were withdrawing our living expenses from our portfolio (before my wife returned to work), we would withdraw as needed, every few months or so. Some might suggest withdrawing monthly, using the CAPE-based withdrawal strategy to get a yearly sum, and then simply dividing that by 12 for the monthly withdrawal.

I’ve highlighted below a theoretical portfolio and CAPE-based withdrawal strategy, starting in early 2020 when I left my job. Note: these are not our actual spending or portfolio values. For Karsten’s modified and evergreen CAPE values, go here. 

Ugh! This is All So Confusing

I know. Saving for retirement is significantly simpler than spending in retirement. Who knew that saving would be simple and spending would be complicated! What a world…

The good news is that many of you are not early retirees. Good. You get to enjoy the enhanced purchasing power of a bear market, where shares are currently on 25% discount. As I discussed in last week’s newsletter, a bear market early in an investor’s accumulation phase is surprisingly good news. Well, so long as your income isn’t adversely affected by a recession. For the early retiree, however, the opposite is true. That’s why we need to be especially mindful of our withdrawal strategy in these times.

If this all seems too complicated, here’s my simplified advice:

1. If you are interested in true early retirement, start with an initial withdrawal rate of 3.25%. In other words, a retiree with an initial spending of $40,000 would need to save $1,300,000, not the $1,000,000 as prescribed by the 4% rule.

2. Don’t retire. Honestly, I think early retirement in its purest form (i.e., doing nothing and making no money) is a mistake for young people, arguably even for traditional retirees. I believe a life of leisure is wasted human capital. As Peter Beal said: “Don’t quit your job. Find your job.” Some version of financial independence can certainly facilitate us “finding our job” when we’re not worried about the next paycheck.

3. Build a hybrid strategy that involves saving and working now. Build a nest egg with work that is compatible with your desired lifestyle. Avoid the temptation to do whimsical things like chasing our dreams. Eventually transition to part-time or low-paying work that might actually be your dream. That reduced income, when combined with an investment portfolio, optimizes your innate human capital and your desire to be part of something that matters. You can utilize some investment income, perhaps using the withdrawal strategy described above. In tandem with your more modest income sources, your investment portfolio can grow and provide financial stability in your later years while allowing you to pursue meaningful work now. If you guys have more questions on how this might look in finer detail, drop me some words in the comments.

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