If you follow the FIRE movement (financial independence, retire early), then you may know about the 4% rule.  This is a general rule about figuring out how much you need to retire, which includes retiring early in life.

For example, let’s say that your living expenses are $40,000 per year, and you plan to keep a similar lifestyle.  According to the 4% rule, you need $1 million in order to retire financially free, assuming you can maintain the same lifestyle.  4% of $1 million is $40,000.

If you want to live on $80,000 per year, then you will need $2 million in assets in order to retire.

You shouldn’t include the equity in your house, unless you are factoring that into your cost. If you own a one million dollar house outright but have no other money, then you are obviously not financially free if you keep owning the house and living in it.  If you want to include a house that is paid off, then you have to include what it would cost you with a mortgage as part of your living expenses.

I have heard a few people say that 3% is the new 4%.  In other words you should be conservative and use a 3% rule.  So, if you are going to live on $40,000 pear year, then you would need about $1.333 million.

Still, most people who are even talking about such a rule are using 4%.  Therefore, that is what I will discuss here.

To be fair, even those who use the rule, use it as a general guideline.  I think most would admit that there are nuances.

I think the biggest factor is age.  If you are 70 years old and you have a million dollars and live on $40,000 per year, then you will probably be fine, assuming you don’t need full-time care in a nursing home (which may still be assuming too much).  If you are 30 years old with a million dollars and currently live on $40,000 per year, I don’t think you have any chance of making it financially without working again.

The 4% rule assumes that you will only draw interest (which really includes dividends and capital gains) from your investments.  You will make 4% on your investments, and you will use that money to live, while keeping the principal intact.

The return on your investments will likely vary.  You probably aren’t going to have some kind of annuity for life, and if you did, it wouldn’t be paying out 4% right now.  The only way I could possibly see getting a relatively steady return on your money of 4% is by investing in residential real estate.  But even here you have to factor in all of the maintenance costs and vacancies.  There is also no guarantee that the rents will not go down.

Those who put faith in the 4% rule don’t expect an exact 4% return every year.  They actually count on a higher return overall, but that will include some down years.  They hope that the good years will more than offset the bad years.

The Inflation Factor

If you can’t already tell, I am not really in favor of using the 4% rule for determining early retirement (or maybe any retirement).  I think it is useful as a measuring stick, but it may steer some people the wrong way.

Let’s say someone is 40 years old.  Let’s say they were lucky and skilled enough to obtain $1 million in assets.  Let’s say they are frugal and live on just $40,000 per year.  If that person wants to take a couple of years off of work to travel, I would tell them to go for it if that is what they want.  If they want to take their dream job that only pays $12 per hour, I say go for it.

However, I don’t think this person should retire with the expectation of never working again for money.  I just don’t think a million dollars will last that long.  If technology improves, or even if it doesn’t, this person could live another 60 years.  A million dollars simply will not last.

We live in a world of central banking where there is almost constant inflation.  If prices go up only 1% in a year, the central bankers are complaining about the lack of inflation.  Most of them say they want at least 2%.  But actual price inflation is impossible to measure precisely.  Sometimes the government statistics underreport the actual inflation due to the weighting and other factors.

Let’s say that you get price inflation of 3% per year.  Using another rule – the rule of 72 – this means that prices will double approximately every 24 years.  This means they will quadruple after 48 years.

Our hypothetical person who is 40 years old will see his cost of living go up by four times by the time he is 88 years old.  If he still has the same lifestyle (which is assuming no additional medical costs), then he will be living off of $160,000 per year.

If we see a decade like the 1970s where price inflation was in the double digits, then most of the 4% rule retirees can start looking for work again.  A decade of 10% annual inflation will likely devastate these people.

I know that defenders of the 4% rule will say that the rule takes inflation into account.  In other words, if you have 4% price inflation, then you should expect 8% returns.

The problem is that we live in the real world.  There is no guarantee of annual returns of 8%. The stock market in Japan is lower now than it was 30 years ago.  Anyone who used the 4% rule in Japan in 1989 and invested in stocks would have been back to work within a few years.

There is a tradeoff between keeping the nominal principal amount safe and hedging against inflation.  You could keep a million dollars in a savings account and make 1% per year, but that wouldn’t even guarantee to last you 20 years living off $40,000 per year.  That is because of inflation.  After 10 years, you may be spending $60,000 per year for the same lifestyle that $40,000 bought you 10 years prior to that.

Meanwhile, if you get too aggressive with your money, you risk losing the principal amount. If you put a million dollars into stocks, it may only be worth $700,000 the following year if there is a bear market.

This is why it is so hard to plan for retirement.  The inflation factor makes it extremely difficult.  And this is the main reason that it makes the 4% rule highly unreliable.

I think it is fine to use the 4% rule as a general measuring stick, but I would not recommend basing your entire retirement on this.  There needs to be some flexibility because nobody can predict inflation or investment returns.