3564: The 4% Rule and Why We're Not Relying on It by Kiersten Saunders of Rich and Regular on Flexible Retirement

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[00:00:47] This is Optimal Finance Daily, The 4% Rule and Why We're Not Relying on It by Kiersten Saunders of richandregular.com I don't remember everything about that day, but it's safe to say that my brain exploded when I learned about the 4% rule. I don't recall which blogger or financial article introduced me to the concept, but I know I've learned a little from a number of places.

[00:01:17] I also remember being skeptical, which led me to search for varying explanations from those who might debunk the math as a myth. But I never found it. What I did find was a tribe of adventurous, smart, and quirky people in the fire movement, who each had their own way of explaining it. And my life hasn't been the same since. With a vision for the future, a group of online homies cheering me on, and now a formula, I knew exactly what I needed to do.

[00:01:48] Shortly after that day, I remember crunching some numbers, reviewing various paths to get there, and challenging myself to be a millionaire by 2020. For a 27-year-old grad student, it was exciting and overwhelming at the same time. We referred to our plan to achieve financial independence and retire early, but haven't gone in-depth about the underlying math behind this decision. This is for several reasons.

[00:02:15] One, we're not financial educators and don't particularly enjoy presenting data this way. We're much more comfortable presenting concepts and applying tolerable doses of math so that our and your brains don't go numb over minutiae and interpretations of data. Secondly, there are plenty of people who have broken the 4% rule down in great detail, so it doesn't make much sense to replicate those bodies of work.

[00:02:43] Most importantly, while we plan on following it, we're not betting the farm on it. But considering we've built our own humble group of followers, allow me to explain the 4% rule as I understand it. In a nutshell, it goes a little something like this. A well-balanced, cost-effective portfolio can withstand an annual withdrawal of 4% into perpetuity. That's it.

[00:03:08] Put another way, if you can save 25 times what you typically spend in a year and invest that savings into a well-balanced and cost-effective portfolio, then you can safely withdraw 4% from that fund on an annual basis and never run out of money. This works because you're primarily withdrawing the earned interest or growth and not the principal, your contribution.

[00:03:32] In absolute simplest terms, if you can live below your means, save up a ton of money and invest it well, then you can live off the interest your investments produce. This is possible because on average, the S&P 500 has delivered annual returns of about 10%. Secondly, if you've built a portfolio that isn't saddled with high fees, the growth, if reinvested, remains in your portfolio, further boosting your returns.

[00:04:02] Combined, those three forces, low cost of living, steady growth, and low investment fees, allow your portfolio to withstand a modest withdrawal continually. When you reach that point, you're considered financially independent, or FI, because you can live off the money your investments produce. We like to think of it as our money making money so we don't have to. This fund is also commonly referred to as your FU fund.

[00:04:31] I'm sure you can see why. Though this is a personal finance blog, I also like to think of the 4% rule in business terms. In that sense, I define financial independence as the break-even point of life, or the point where your fixed cost of living is covered. Any earnings above and beyond that point is pure profit, or in personal finance terms, disposable income. That's key, because while we do have our eyes set on opting out of work,

[00:05:00] we will certainly continue to earn money. The difference being, it will be on our terms. So what are we going to do? In general, our goal is to pour as much of our disposable income into a portfolio that will allow us to withdraw 4% from it, so that we can opt out of required work if we wanted to. But what makes our situation a bit more interesting is we're not completely hitching our wagon to a portfolio in the market to produce income for us.

[00:05:30] Instead, we're diversifying this approach by supplementing our nest egg with other sources of income. Think about it this way. On one hand, we could build a giant nest egg of low-cost index funds and bonds and slowly pull from that over time, adjusting the allocation as we get older. The risk is, when the market is doing backflips, we have to practice Jedi levels of aggressive patience as we watch our moolah ride a roller coaster.

[00:05:57] As we get older, that'll likely get harder to do because we'll have a child, maybe more, likely need more healthcare, and have expenses to consider that we don't have today. So what did we do to hedge that risk? We invested in real estate. This way, we're not solely reliant on our stocks and bonds portfolio and the 4% rule to produce income for us. Instead, we'll have debt-free rental properties that supplement our income.

[00:06:26] Not owing a mortgage on our rental properties boosts cash flow, so long as we have tenants and will cover a significant portion of our new mortgage. The only costs for our rentals will be operating costs, that is, management fees, repairs, insurance, HOAs, and property taxes, admin costs, like legal fees, and capital costs, like long-term repairs. So if you tie the two together,

[00:06:52] you can say our rental properties relieve the pressure from us to build a massive nest egg because we've built other vehicles of income. Not to mention, the properties could appreciate in value and are great tax shelters for us. But we're not stopping there. Taking a page from a millionaire's mindset, we're actively building other streams of income that fit our lifestyle and skill sets. Here's how I look at it. You can go after the big job, the fancy title,

[00:07:20] and the corporate perks that come with it. In exchange for that, you don't own your time, your productivity and security is limited to the whims of that organization, and likely several other forces that are completely out of your control. Or you can trade in the big old check life to create several smaller checks that produce the same, if not more, income passively. What we love about this approach is it gives us multiple streams of income while having more flexibility to spend our time

[00:07:50] doing more of the things we love. It could be investing in a franchise, monetizing this blog, consulting work, micro-investing, etc. The point is, we'll be in control, which you can't say when you're bound to one paycheck at a job. So there you have it, folks. That's the underlying math and some more on our approach in a bit more detail. Whether you agree or not, the gist is the same. If you're in a position to explore alternative ways of earning income

[00:08:19] and are interested in owning more of your time, you should consider this approach of front-loading your retirement. You just listened to the post titled The 4% Rule and Why We're Not Relying On It by Kiersten Saunders of richandregular.com I don't know about you, but even with regular cleaning, it seems like dust is never ending. That's why so many listeners have discovered Air Doctor, the air purifier that's changing how people breathe.

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[00:09:47] using promo code OFD. Dell PCs with Intel inside are built for the moments that matter, for the moments you plan and the ones you don't, built for the busy days that turn into all-night study sessions, the moment you're working from a cafe and realize every outlet's taken, the times you're deep in your flow and the absolute last thing you need is an auto-update throwing off your momentum. That's why Dell builds tech that adapts to the way you actually work,

[00:10:17] built with long-lasting batteries so you're not scrambling for the closest outlet, and built-in intelligence that makes updates around your schedule not in the middle of it. They don't build tech for tech's sake, they build it for you. Find technology built for the way you work at dell.com slash dellpcs. Built for you. The 4% rule is discussed constantly in various FIRE forums and online groups

[00:10:47] and for good reason. Most of us are creating financial targets and plans around this rule, but I like to think of it as a guideline more than a rule. It's helpful as a way to determine that you have enough money to quit your job, but it's not really a withdrawal strategy. There are many factors that the 4% rule doesn't consider, especially for early retirees. The Mad Scientist shared a blog post in collaboration with Nick Majuli to expand on this.

[00:11:16] It's called The Problem with the 4% Rule and Why You Could Retire Even Sooner, if you'd like to check it out. They argue that this rule doesn't account for the flexibility that most early retirees have, as demonstrated in the article today. Many people who quit required work move on to fun employment, or they create other more passive streams of income where they simply don't need to sell investments for income. The 4% Rule assumes

[00:11:45] that you have no other income and you will never have any other income for the rest of your life, which for most people isn't true. Social Security is going to kick in at some point, if nothing else. It also assumes that you will never decrease your spending for any reason. It doesn't consider when Medicare kicks in and reduces your healthcare costs, and it assumes that your personal rate of inflation will match the overall rate of inflation, which for the frugal among us is laughable.

[00:12:14] While the 4% Rule is very helpful, it can also cause fire enthusiasts to delay making big, meaningful changes in their lives or obsess over moving the goalpost. But that's a wrap for another Monday show. Have a great rest of your day and start to your week, and I'll be back tomorrow where your optimal life awaits. That's a wrap for another month. Let's see. You might hear Let's see. The next one. Bye-bye. Bye-bye. Thank you.