The Four Percent Rule for FIRE - The Definitive New Zealand Guide to a Financially Secure Retirement

Our guide explains the 4% rule, how it works, and whether it still applies to FIRE followers in a low-interest-rate environment

The Four Percent Rule for Retirement Income NZ

Updated 3 December 2021

Know This First: Is the 4% Rule Dead, and How Much do I Need to Retire?

It is well known in the FIRE community that you need 25X your annual expenses to "retire early".
Many of the first FIRE followers established this rule when interest rates were around 3% to 5% (meaning you could get term deposits that paid out 3 - 4% a year in interest or bonds that provided around 5% in interest payments).
In the early 2000s, this rule worked like a charm. You could generate more income on your nest egg than inflation and pay off your annual expenses without touching your initial amount. However, in a low-interest rate world, this may no longer be the case.

To help explain the 4% Rule and test its validity, our guide covers:

More information: Visit New Zealand's Financial Freedom Authority - The Happy Saver. Ruth is a proven expert and has helped hundreds of New Zealanders on their journey to financial independence. Ruth also offers a phone-a-friend service which we believe is a helpful starting point to mapping out the financial situation you want to achieve. MoneyHub has no financial relationship with The Happy Saver, and mention it given its popularity, relevance, usefulness and trust.

What is the 4% Rule?

The central question for many FIRE followers is how much you need to save to "retire early". Once this is set, the next question is how much of your retirement savings you can spend each year to not run out of money. Unfortunately, figuring out the right withdrawal rates ("WR") can be uncertain and difficult – not only as your life situation (and corresponding expenses change) but also as the world changes around you (e.g. from boom to bust, from economic growth to a recession, from high-interest rate to low-interest-rate environments).

Historically, in the first year of retirement, retirees could safely spend around 4% of their retirement savings and could modify the annual withdrawal rate to account for inflation in the following years. Most retirement portfolios can survive at least 30 years by following this principle and can last up to 50+ years. The 4% rule is an intuitive, easy to use rule of thumb for those in retirement. However, many people misapply or fail to recognise the key assumptions underlying this rule.

How the 4% Rule Works

The 4% rule states that you can withdraw up to 4% of your portfolio's value each year. So, for example – if you have NZD 1 million set aside for retirement, you could spend $40,000 in your first year of retirement.
Beginning in the second year of retirement, you adjust this amount for inflation. For example, if inflation was 2%, you could withdraw $40,800 ($40,000 x 1.02). In the unlikely event that prices fell by 2%, you would withdraw less money than the previous year ($39,200 in our example ($40,000 x 0.98). In the third year, you would take the previous year's allowed withdrawal and adjust that amount for inflation.
The 4% rule states that retirees should withdraw 4% of their portfolio's worth each year during retirement – this is frequently misunderstood. The 4% rule only applies in the first year of retirement. The amount withdrawn is then determined by inflation.
The goal is to keep the 4% withdrawn in the first year of retirement's purchasing power. However, this example does not include the existing $1 million growing (it assumes you have the entire portion in cash). This is typically not advised, especially for FIRE followers, given most will retire at 40 – 50 years of age with a runway of 50 years to go.
Most FIRE followers will reinvest this into either term deposits, bonds or equities. This is a common misunderstanding with the 4% rule.

Deconstructing the 4% Rule

The 4% rule is based on many underlying assumptions that must be understood. The 4% rule is based on specific asset allocation requirements – and many other factors, including fees, inflation, expected return and risk, can all affect the outcome.

Asset Allocation
Assuming the portfolio is split 50% equities (e.g. S&P 500 or NZX 50) and 50% bonds (per this study):

3% withdrawal rate: The portfolio can comfortably last 50+ years.
4% withdrawal rate: The portfolio will likely last up to 50 years. However, in some of these scenarios, the portfolio may only last 30 – 40 years (e.g. the stock market may have chronically underperformed in certain periods).
5% withdrawal rate: More than half of the example portfolios were depleted in less than 50 years, with the weakest portfolios lasting <20 years.
6% withdrawal rate: Only seven portfolios survived 50+ years, while many lasted <20 years.

The above analysis shows that the higher your withdrawal rate, the shorter you can expect your nest egg to last. Note, however, that this is based on past returns. Future returns may not mirror that of the performance we have seen from 1950 – 2020. Some analysts expect the period ahead (2020 – 2050) to return relatively less than historical returns.

Know This: Another key result from the analysis is that keeping too few stocks is worse than holding too many stocks. Portfolios with stocks allocations ranging from 0% - 25% burned through the nest egg faster than those with higher equity allocations. If the only goal is portfolio longevity, a 50/50 allocation is better than more defensive options (e.g. a higher allocation than 50% in bonds and cash).

If the goal is wealth accumulation (which may be the goal for early retirees aged 40 – 50 years old), increasing the stock allocation to around 75% is best. A 50/50 portfolio is too risky for some retirees, making a 75% stock allocation a significant risk. However, research suggests that for the 4% rule to hold, a stock allocation of 50% to 75% is the best way to do this.

The Impact of Fees

The above analysis does not consider fees for trading stocks or bonds or fees applied to ETFs, mutual funds or KiwiSaver returns (our fund fees calculator visualises these). The likely impact of fees will reduce the overall returns throughout a portfolio's lifetime – making the above estimates somewhat optimistic.

It is common for investment advisors to charge 1% of assets under management as an annual fee. Total costs can approach or even exceed 2% if the advisor chooses actively managed mutual funds, which typically charge 75+ basis points each year (for example – the Booster's Geared Growth KiwiSaver fund's total fees of around 1.61% of assets – which is high for a KiwiSaver fund). The 4% rule may not apply if above-average fees are paid. Opting for the low-cost index fund option is arguably an optimal solution for many early retirees. To reduce fees, please see our Favourite KiwiSaver and Investment Fund guides.

Historical Returns Extrapolated into Future Returns
One of the biggest risks to the 4% rule is if there's a period of bad market returns in the initial years you retire – which can deplete the investment portfolio well before 30 years. Alternatively, suppose one retires at the start of a bull market with strong investment returns. In that case, this can significantly enhance a portfolio's worth, leaving a retiree who follows the 4% rule with a considerable balance even after 30 years have passed. Of course, there's no way to tell what the markets will do once you retire, but being aware of this fact (and potentially guessing which stage the markets are at generally) can help.

Regardless of the plan, the main issue for retirees is that market performance cannot be predicted in the future. For example, a person retiring in January 1929 would have no idea that the Great Depression would begin in one year, where markets crashed 50%+. Similarly, someone retiring in January 2009 would have no idea that the market would reach the bottom in 3 months and rally into one of the world's longest bull markets in history. The 4% rule and retirement plans generally should take into account such swings. However, people who began retirement around market dips still their portfolios last 30+ years if they followed the 4% guideline.

Inflation Impacts

Inflation can significantly impact a retiree's overall portfolio. While retirees' portfolios may face considerable losses, they can minimise the number of annual withdrawals they make during this time and keep their money's purchasing power. Understanding what is essential and what is not in a retiree's yearly expenses can help to ease inflation concerns. Additionally, inflation in typical consumer goods will typically be offset by the performance in the stock market (higher prices can influence higher stock markets).

Dynamic Withdrawal Rates

The 4% rule assumes a constant withdrawal rate during retirement. In the first year of retirement, retirees will take out 4% of their nest egg. Following that, they can adjust their annual withdrawals to account for inflation or deflation. Dynamic withdrawals, on the other hand, provide retirees with a lot of freedom. In the event of a market downturn or unexpectedly high inflation, a retiree can cut their annual withdrawal by 5%. While a 5% reduction may not seem like much, it can make a big difference in the life of your nest egg.

Problems with the 4% Rule (and Testing its Assumptions)

The biggest problem with the 4% rule is the method of calculating what proportion you'll need to save to make sure you won't run out. Figuring what proportion of money you'll get to last an unknown period is not easy. FIRE followers promote saving a minimum of 25X your current annual expenses so that by the time you retire, you'll believe the 4% rule. However, various assumptions must be valid for the 4% rule to work.

Below are the top three assumptions that need to be correct for the 4% rule to hold:

1. The portfolio must grow.

The 4% rule assumes that an investment portfolio will grow at the same rate as equity markets have grown in the past (typically 9 – 10% per annum). This effectively assumes the future will look (and return) the same as the past.
However, there are long periods where significant falls in stocks have reduced the typical annual returns to well below 10% (and vice versa).
In the next decade, equity returns are expected to be lower than they were over the last decade across both stock markets and NZ government bonds.
This means FIRE followers using the 4% rule may be overestimating the growth of their portfolios (and may draw down more than they expect to over the first few years).

2. The time period is certain.

The first 4% rule formula assumes average annual growth of 8 – 9% and 4% annual drawdown – this is expected to continue for 30 years, considering a typical range of potential market swings experienced through history.
However, people are typically living longer on average (e.g. most humans born in 2000 will live into their 80s). Not only that, but FIRE followers will retire earlier than 65, meaning their retirement timeline may be up to double the typical 20+ year retirement.
FIRE followers may have to tweak their portfolios towards heavier equity allocations if they want their nest egg to last longer.

3. Other factors are not factored in (e.g. inflation, fees, changes in situation).

The 4% rule assumes that the expenses you have when you initially retire will not change – e.g. if you use $50,000 in annual expenses for your family – this is unlikely to change. In reality, people's financial and life situations continue to change, which will impact how much you spend.
If you're suddenly responsible for another dependent (e.g. a young child or your parents), you lose your job or become incapacitated – the 4% rule breaks down. On the flip side, the financial dynamics might benefit you (e.g. you inherit a windfall or enjoy a rapid increase in salary).
Each of those instances will alter the time it takes you to succeed in your required retirement age.

Testing the 4% Withdrawal Rule

Let's assume you have accumulated $1 million in your bank account after years of working. A key question is how you're able to safely withdraw the $1 million and not run out of cash before you die. The two main options are to draw down the cash as required or conserve to ensure the nest egg lasts for the remainder of your family's life.
In the low-interest-rate environment we are currently in, it may be prudent to reduce the expected drawdown rate in light of a bleaker future – so a 3% or 3.5% withdrawal rate can work better.
On the other hand, future inflation may also make the 4% withdrawal rate too high. Still, others find 3% too low to live on and will need a higher nest egg to retire on.
So, overall, the 4% withdrawal principle makes sense in theory, but in reality, it may need to be reduced if the financial markets underperform.

Frequently Asked Questions

The 4% rule is not without its critics - we answer common questions below to help you understand what's important (and realistic).

Can I safely draw down 4%? It seems like this is a bit much

It can feel overwhelming to work out the way to make your nest egg last. However, it is a fortunate problem to have. People within the bottom half of the wealth distribution may retire on nothing (and expect New Zealand Superannuation to support them). Some may still not fully own a house or have much savings. Planning far in advance is a great way to prepare for any economic environment.

Trying to save 25X of my annual expenses seems crazy – how can I ever save that much?

The goal of saving 25X your income is lofty – but it is not impossible by any means. Unfortunately, many people have unrealistic expectations as to how quickly they need to accumulate that much. Like how a snowball starts small and grows very quickly, your savings will feel like they're not growing fast (until they grow extremely fast). Realising that this goal may take 10 – 20 years to materialise and manage those expectations is the key thing to take away.

Is the 4% Rule Still Valid?

Some have questioned whether the 4% rule is still true in recent years. They argue that high valuations result in poor expected returns from equities. They also point out that with interest rates so low, bonds and term deposits yield less than 1% p.a, making it difficult to reach the 4% drawdown target.

While both worries are valid, the 4% rule has shown to be reliable in various challenging environments. While nobody can predict the future, history suggests that the 4% rule is a reliable way to estimate how much one can spend in retirement.

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