If you want to be financially free, you must understand the importance of the FIRE movement.
FIRE stands for “Financial Independence, Retire Early”.
The FIRE movement is a lifestyle community with the goal of gaining financial independence and retiring early.
Upon reaching financial independence, paid work becomes optional, allowing for retirement from traditional work decades earlier than the standard retirement age.
The goal is to save and aggressively invest roughly 50 to 75 percent of your income so you can retire at 30 or 40.
That’s right: You need to save at least half your income.
What is the 4% Rule for the FIRE movement?
The 4% rule is one of the pillars of the FIRE movement.
If you want to achieve FIRE you must know the Four Percent Rule..
The “Four Percent Rule” is simply a rule of thumb.
It is an informal piece of practical advice used to determine how much you, as a retiree, can withdraw from your retirement account each year.
You need to apply this rule if you want to provide a steady income stream when you are retired, maintaining at the same time a balance in your account total net worth.
Understanding the 4% Rule
The 4% Percent Rule can help you as a future retiree to set a portfolio’s withdrawal rate.
Obviously your life expectancy plays a crucial role in calculating this number: the longer your life will be, the more you need to increase the amount of your total portfolio, or decrease your withdrawal rate (i.e. to 3,5 -3%).
History of the 4% Rule
The 4% Percent Rule was created using historical data on stock and bond returns over the 50-year period from 1926 to 1976.
Before the early ‘90s, it was a common opinion among the experts that a 5% withdrawal rate would be a safe amount for retirees to withdraw each year.
William Bengen, an American financial advisor, conducted a complete analysis of historical returns in 1994, focusing heavily on the severe market downturns of the 1930s and early 1970s.
Bengen’s analysis concluded that there was no historical case in which a four percent annual withdrawal exhausted a retirement portfolio in less than 33 years.
Accounting for Inflation
The rule allows retirees to modify and increase the withdrawal rate to keep pace with inflation.
There are two possible ways to adjust the withdrawal rate for inflation: 1) setting a flat annual increase of 2% per year (which represent the Federal Reserve’s target inflation rate); 2) adjusting withdrawals depending on actual inflation rates.
The first method provides a regular and constant increases; the second tries to exactly match the income to actual cost-of-living.
When you have to Avoid the 4% Rule
In some cases the Four Percent Rule will not work for a retiree.
An intense and extended market downturn will erode the value of a high-risk investment vehicle much faster than it can an ordinary retirement portfolio.
Also, the Four Percent Rule does not work if retiree won’t remains loyal to rule itself.
Violating the rule, and spending more than four percernt to do a major purchase will have severe outcome.
It will have a direct impact on the compound interest of the investment on which the retiree depends for the living expenses.
The Four Percent Rule and Economic Crises
Michael Kitces, an investment planner, says that the 4% Rule was developed to take into account the worst economic situations you can imagine, such as 1929, and has held up well for those who retired during the two most recent financial crises.
Kitces points out: “ The 2000 retiree is merely “in line” with the 1929 retiree, and doing better than the rest. And the 2008 retiree—even having started with the global financial crisis out of the gate—is already doing far better than any of these historical scenarios! In other words, while the tech crash and especially the global financial crisis were scary, they still haven’t been the kind of scenarios that spell outright doom for the Four Percent Rule.
Even considering that the long-term historical average return of a balanced (60 stocks/40 bonds) portfolio is almost 8%, it is not recommended to go beyond the rule: the safety of an investment is a crucial element for a retiree, even if following an extremely safe approach can cause “a huge amount of money left over “.
How much money will you need for retirement?
There are two very popular rules of thumb used in the FIRE movement.
The “Multiply by 25” rule and the “4 Percent” rule.
They are frequently confused but they are very different: the first tells you how much you should save, the second calculates how much money you can safely withdraw year by year.
Let’s analyze both in more detail
The “Multiply By 25 Rule”
The Multiply by 25 Rule calculates how much money you’ll have to invest to reach Financial Freedom or Early Retirement.
You can easily calculate this amount by multiplying your annual income by 25.
For example, if you want to withdraw 40.000 $ per year, you need to have $1 million in your investment portfolio ($40000 x 25 equals $1 million.)
If you want to and live with $30,000 per year, you need $750.000 in your portfolio.
This rule of thumb estimates the amount that you can withdraw from your portfolio without depleting it.
The 4% Rule
This rule of thumb presume your portfolio will be capable to give a minimum annualized return of 4 percent per year.
It assumes that your stocks, in the long run (more than 15 years), will produce an annual return of about 7%.
In the meantime, inflation will erode the value of the dollar at roughly 3 percent per year.
It means that your “real return” after inflation will be about 4 percent.