Risk of using 4% rule for your FIRE journey

Though this is an extreme example, but this is just a 7 year scenario. If you consider a 30-year scenario, duration for which a typical retirement lasts, the sequence of returns can have a huge impact on your portfolio value.

Mitigating Sequence Risk

The 4% Rule: –

The 4% rule is the safe withdrawal rate which minimizes the risk of you outliving your savings.

It’s pretty simple. In the first year of your retirement, you withdraw exactly 4% of your portfolio, and from the second year onward, you increase the withdrawal amount by the rise in the cost of living (inflation).

For example, if you have Rs. 1 crore saved up in your retirement account, you would withdraw Rs. 4 lakhs in the first year of retirement.

In the second year, you would adjust the withdrawal amount for inflation. For instance, if the inflation rate was 5%, you could withdraw Rs. 4.2 lakhs (Rs. 4 lakhs + 5% inflation).

The rule claims that if you follow this approach, your retirement savings should last at least 30 years and sometimes even as long as 50 years.

However, there are some limitations to the rule which you must consider: –

Firstly, the study was conducted in the US market and there is not enough evidence to confidently suggest that it would work in developing markets like India.

Secondly, the study was conducted almost 30 years ago with market data going back as much as 100 years. A lot of changed since then, information is more readily available, and it is much easier to invest today than it has ever been. Past returns might not prove to be a good indicator of the expected future returns.

The success rate of using 4% rule in India is 81% for a 25-year retirement. This reduces to 62% in case your retirement period is 35 years.

What can we do to increase the chances to you outliving your retirement corpus. 

Dynamic Spending Rate: –

One simple approach to mitigate sequence risk is the concept of a dynamic spending rate. This strategy involves adjusting your annual withdrawal based on your portfolio’s performance and remaining balance.

In the good market years, you increase your withdrawals and in the bad market years, you adjust your withdrawals downward. 

This way you can minimize both the downside risk (the risk of running out of money in retirement) as well as the upside risk (the risk of not fully enjoying your wealth). 

For instance, you might start your retirement with a 4% initial withdrawal rate, but with a plan to increase spending by 10% anytime the current portfolio is up at least 50% from where it started, and vice versa should the opposite happens. 

This way, during favorable sequences, spending increases over time to utilize the extra retirement assets, while during unfavorable sequences, spending remains conservative to ensure sustainability.

Another Dynamic Spending approach is to use some sort of guardrails.

Assuming a 4% initial withdrawal rate, spending would be reduced if ongoing withdrawals as a percentage of the portfolio rose above 5% (because spending was dangerously outpacing portfolio growth), while spending would be increased if withdrawal rates dropped below 3% (because portfolio growth was outpacing spending growth). The outcome is a spending rate that changes dynamically as the scenario plays out. with the potential for raises if the sequence turns out to be more favorable but also with the potential for cuts if the sequence is unfavorable.

Research has shown that using some sort of dynamic spending can increase the success rate of you outliving your portfolio by as much as 10-20%

Conclusion

Sequence risk is a crucial aspect to consider in retirement planning. Experiencing poor investment returns early in retirement can significantly impact the sustainability of your savings.