When working towards Financial Independence Retire Early (FIRE), most people follow the 4% rule, i.e. to accumulate at least 25 times their annual expenses and invest the money in income-generating assets. Call us overly cautious, but we accumulated 35 times our annual expenses instead. We’re glad we did. Read on to find out why.
Mr Wow and I achieved financially independence in 2019. In 2020, we sold our small business and retired at the age of 45 and 42 respectively. FIRE is not for everyone. It is an alternative lifestyle, the exception rather than the norm. To get there, you need meticulous planning, economic discipline and prudent investment.
If you don’t know much about the FIRE movement, fret not. I’ll cover the basics of FIRE and the 4% rule before touching on our FIRE strategy.
- What Exactly is FIRE?
- How to Achieve FIRE with the 4% Rule?
- Top 5 Commonly Asked Questions About FIRE
- Why We Didn’t Follow the 4% Rule Entirely
- Our FIRE Strategy Revealed
1. What Exactly is FIRE?
FIRE is a movement that encourages people to achieve financial independence, which is the state of having sufficient money to pay their living expenses for the rest of their lives without having to rely on a job or others. This allows them to retire early or do something they enjoy rather than something they have to do in order to make a living. The main focus of FIRE is the first component: financial independence (FI). The decision to retire early (RE) or not is entirely up to the individual. Some people might prefer to continue working because they enjoy it; others might want to amass more wealth.
The journey to FIRE is a life-changing experience, to say the least. Through the process, you will learn how to take control of your financial situation and live a highly fulfilling life while consuming less.
The main focus of FIRE is the first component: financial independence (FI). The decision to retire early (RE) or not is entirely up to the individual.
Check out: Embracing Early Retirement: Why I Don’t Miss Work
2. How to Achieve FIRE with the 4% Rule
Many people in the FIRE community attained financial independence in their 30s or 40s. They were able to do so by saving aggressively and investing wisely. The 4% rule is by far the best-known strategy for achieving FIRE.
The rule was first articulated by American financial advisor William Bengen in 1994. Bengen conducted a detailed study on actual stock returns and retirement scenarios over a span of 75 years, which included major world events such as the Great Depression, Arab oil embargo and Gulf War. The conclusion: a person could draw down 4% on his or her retirement portfolio (50% stocks and 50% Treasury bonds) in the first year, followed by inflation-adjusted withdrawals every subsequent year without fear of running out of money over a 30-year period. Yep, that’s right. Such a portfolio was able to survive any 30-year sequence found in history. The rule was further popularised by the Trinity study in 1998. Since then, it has become a benchmark for many in the financial service industry, as well as the FIRE community.
According to Bengen, a portfolio of 50% stocks and 50% Treasury bonds was able to survive any 30-year sequence found in history.
3. Top 5 Commonly Asked Questions About FIRE
Although the 4% rule is well-covered territory, many people are still not completely sure how it works, so here are the answers to some of the most commonly asked questions.
Q1: Where do I start if I want to achieve FIRE?
► STEP 1: You need to get a full picture of your financial situation by calculating your net worth, i.e. total assets (what you own) minus total liabilities (what you owe).
► STEP 2: You need to track and calculate your annual expenses. If you plan to maintain your expenses at the same level after retirement, your FI figure (i.e. the sum of money you need to be financially independent) will be your annual expenses divided by 0.04.
For example, Sam intends to spend $60,000 a year when he retires. His FI figure will be: $60,000 / 0.04 = $1,500,000 Another way to calculate: $60,000 x 25 times = $1,500,000
► STEP 3: You need to invest your FI figure in income generating assets, not hide the money under your mattress. Based on the 4% rule, that means a 50:50 stocks/bonds mix.
In Sam’s case, that’s: $750,000 (50%) in stocks, and $750,000 (50%) in Treasury bonds
Based on Bengen’s study, such a retirement portfolio will generate enough passive income and capital appreciation to allow you to withdraw 4% each year (inflation-adjusted) for at least 30 years. Please note the 30-year period. It’s NOT a lifetime. I will address this later in the article.
Q2: How long does it take to reach my FIRE goal?
How soon you can achieve FIRE depends on two factors: (1) your annual expenses, and (2) your savings rate.
► The lower your annual expenses, the smaller your FI figure. It’s simple math. If your annual expenditure works out to be $90,000, you will need a bigger nest egg compared to someone whose annual expenditure is $60,000. Someone who only spends $45,000 a year needs even less.
$90,000 annual expenses = $2,250,000 FI figure $60,000 annual expenses = $1,500,000 FI figure $45,000 annual expenses = $1,125,000 FI figure
That’s why the first thing you need to do when working towards FIRE is to reduce your expenses. Live below your means and do not inflate your lifestyle. Eliminate unnecessary spending, but only to the point where you’re comfortable. Some people are fine cutting restaurant meals totally, but if that’s going to make you absolutely miserable, don’t. You could reduce the frequency or opt for a more budget-friendly restaurant instead. Figure out what works for you and your family as you build your wealth.
The first thing you need to do when working towards FIRE is to reduce your expenses.
► The higher your savings rate, the faster you will get there. It goes without saying that your savings rate will increase when you spend less. That gives you more money to invest. The conventional savings rate recommended by most financial planners is 15% to 20% of one’s income. FIRE is anything but conventional. In fact, people in the FIRE community do the exact opposite, spending just 15% to 20% of their income and saving the rest. It takes a lot of discipline, but it’s not impossible.
Check out my two-part series: How to Cut Expenses to Retire Early: Getting Started and Realistic Budgeting
Q3: How do inflation-adjusted withdrawals work?
Simple. In the first year of retirement, you will draw down 4% of the total value of your portfolio. From the second year onwards, you will increase the value of your withdrawals by the inflation rate to maintain your purchasing power.
For example, Sam’s retirement portfolio has $1,500,000. His withdrawals will look like the following: Year 1: $60,000 (4% of $1,500,000) Year 2: $61,800 (3% inflation) Year 3: $63,654 (3% inflation) Year 4: $65,564 (3% inflation) Year 5: $67,531 (3% inflation)
Q4: Are dividends and coupon payments part of the annual withdrawal?
Yes. Let’s look at Sam’s example again:
Sam plans to draw down $60,000 on his portfolio this year. He expects to receive $50,000 in dividends and coupon payments. Therefore, he only needs to withdraw $10,000 from his portfolio.
Given the case, if your dividends and coupon payments fully cover your annual expenses, you do not even have to touch your portfolio!
Q5: Is the 4% rule foolproof?
Nothing in life is guaranteed, but if history is any guide for the future, the 4% rule is, in all probability, safe for 30 years.
To be clear, the rule is not without criticism. A number of analysts have pointed out that 4% is not realistic in a low yield environment. Returns could be lower than historical averages for both stocks and bonds, so the withdrawal rate should be adjusted down. There are also differing views on asset allocation.
Let’s address asset allocation first. Bengen’s study was based on a portfolio of 50% stocks and 50% bonds. However, the allocation can be adjusted according to one’s risk appetite/tolerance — up to 75% in equities but no less than 50%. As bonds typically do not give the returns that stocks do, many retirement experts recommend a 60:40 mix. Such a portfolio adhering to the 4% rule is not only extremely safe over a 30-year period, but also likely to increase/skyrocket in value due to capital appreciation. (To learn more about the different asset classes, do check out this article: 4 Main Asset Classes: A Beginner’s Guide.)
Asset allocation can be adjusted according to one’s risk appetite/tolerance — up to 75% in equities but no less than 50%. Many retirement experts recommend 60% stocks and 40% bonds.
What if you’re looking at a time horizon that is shorter or longer than 30 years? How does it impact the withdrawal rate? In his comprehensive report, ‘20 Years of Safe Withdrawal Rate Research’ published in March 2012, Michael Kitces, one of Investopedia’s top 10 most influential advisors (you gotta check him out) wrote that one can increase the withdrawal rate by 1% for a 20-year retirement and make the portfolio more conservative with a higher bond weighting. For a 40 plus-year retirement, a withdrawal rate of 3.5% (i.e. a 0.5% decrease) is recommended.
To counter market risks, flexibility is key. The 4% withdrawal rate is not set in stone. As you go through retirement, you need to be prepared to adjust your withdrawals when market conditions change. If the market plunges and the value of your portfolio drops sharply (e.g. during the 2008 financial crisis or the more recent Covid-19 crash of 2020), you might want to skip a few inflation increases or slash your withdrawal rate to 3.5% or even 3%. It can always revert to 4% when the market is on a bull run. The bottom line is — DON’T BE RIGID.
The 4% withdrawal rate is not set in stone. As you go through retirement, you need to be prepared to adjust your withdrawals when market conditions change.
Check out: Investing During a Recession: What You Need to Know
4. Why We Didn’t Follow the 4% Rule Entirely
Both Mr Wow and I love to cook. When trying out a new dish, we usually follow the recipe exactly. Sometimes, we will tweak the recipe a little, e.g. reduce the amount of salt or change an ingredient, to suit our taste buds. We definitely do not change everything because doing so will defeat the whole purpose of the recipe.
Our take on the 4% rule is similar to our approach to cooking. The whole idea is to use it as a source of reference or guide, not something that we must follow from A to Z. And as a guide, the 4% rule offers an excellent starting point. There’s no need to reinvent the wheel; we just need to make a few fine adjustments so that it caters for our retirement needs.
Our take on the 4% rule is similar to our approach to cooking. The whole idea is to use it as a source of reference or guide, not something that we must follow from A to Z.
Mr Wow and I didn’t follow the 4% rule in its entirety for the following reasons:
► Longevity Risk: The biggest uncertainty in retirement is longevity. Our portfolio needs to survive much longer than 30 years. Considering our retirement age, a 50-year time horizon is more prudent (assuming that I live till 92 and Mr Wow 95; hope not). That means we need a more modest baseline than 4%. We definitely do not want to outlive our money.
► Market Risk: We also did not eliminate the possibility that we might experience lower-than-expected returns in some years, e.g. a prolonged bear market.
► Inflation Risk: Being an eternal pessimist, I was concerned about inflation too. What if inflation goes out of control and greatly reduces our purchasing power? I guess my worries ain’t unfounded. Just look at this crazy year. The consumer price index in the US accelerated to 9.1% in June 2022, the highest in nearly 41 years. In Singapore, headline inflation rose to 6.7%. That same month, my favourite chicken rice went up by 50 cents, from S$4 to S$4.50. That’s a 12.5% surge!
► Overspending Risk: Needless to say, high inflation will lead to overspending, resulting in insufficient funds in our old age. Horror of horrors!
5. Our FIRE Strategy Revealed
So what’s our game plan? Well, we basically gave ourselves a lot of buffer against the above risks. This way, we can sleep well at night:
► Lower Withdrawal Rate: Instead of drawing down 4% on our portfolio each year, we withdraw just 3%, sometimes less (principal untouched as our dividends and coupons yield more than 3%).
► Higher FI Figure: For the above to happen, we had to accumulate more money, so we kept working and saving and investing till we reached that magic number.
► Equity-dominated Asset Allocation: As a rule, we maintain an equity-dominated portfolio that consists of about 60% stocks, Index Funds and REITs. We usually hold 15% of our portfolio in cash (mostly in high-yield savings accounts and Singapore Savings Bonds) and put the rest in intermediate bonds.
Note: This allocation is considered conservative in the FIRE community. Many who are FIREd hold up to 90% in equities, which we are not comfortable with. Several factors have to be taken into consideration when deciding on your asset allocation. They include your risk tolerance and time horizon. For us, we are comfortable with 60% in equities. Yes, the returns are lower, but so is the risk. That’s why we accumulated a larger nest egg before retiring.
At present, we have slightly more cash than what we normally keep due to three straight years of underspending (see next point). We think it’s important to keep some cash reserves for liquidity and portfolio rebalancing. We also want to have the option to take advantage of market volatility and buy stocks at bargain prices. This current asset mix generates more than enough passive income to cover our annual expenses (yes, there’s surplus). It will in all likelihood evolve as we get older, e.g. we might lower our equity exposure and put more money in bonds when the time is right.
To find out how we maintain a diversified pool of assets for regular income and capital growth, read our articles The Retirement Bucket Strategy Demystified, Why We Love Dividend Investing but It’s Not For Everyone and Beyond Borders: Why Invest in a Global Index Fund.
► Flexible Inflation-adjusted Withdrawals: Despite the higher inflation rate in recent times, our annual expenditure has not risen since 2017, I kid you not. In fact, it dropped in the past three years because we haven’t been travelling due to the Covid-19 pandemic. Thus, there’s no need to make inflation-adjusted withdrawals every year. We do it only when it’s necessary.
► Optional Expenses: We definitely do not lead the high life, but our version of FIRE is neither extreme nor lean. There are some things we’re willing to spend on and one of them is vacation, which we budgeted S$10,000 a year as part of our expenses. This S$10,000 acts as a buffer in times of trouble. In the event of a market meltdown, we will reduce our holiday spending or cut it completely until the shitstorm blows over.
► National Annuity (Buffer): Excluded from our portfolio is our CPF LIFE*, which will provide us with lifelong monthly payouts from the age of 65. After much deliberation, we have decided not to maximise this for now as we value liquidity more. Changes to CPF rules are beyond our control, so any voluntary contribution has to be a carefully weighed decision. That said, CPF LIFE remains on our radar and we do not rule out the possibility of injecting more money into our retirement accounts down the road.
*In case you’re not familiar with Singapore — CPF LIFE stands for Central Provident Fund’s Lifelong Income For the Elderly. It’s a national longevity insurance annuity scheme that provides Singaporeans with monthly payouts from the age of 65, no matter how long they live.
► Golden Age Bonus (Buffer): We also excluded two whole life insurance policies, which we bought when we were young adults, from our portfolio. If everything goes as plan, we will cash out and surrender both policies in our early 70s as we do not have kids/dependents (basically no beneficiaries except ourselves). Our expenses will go down as a result (no more premium to pay) and the total surrender value (approximately S$380,000) will be our golden age bonus. In case you’re wondering, we have ample term insurance to cover hospitalisation and surgery, as well as disability.
All in all, I think our financial health is in good shape as we have a sizeable investment portfolio and ample buffer. ‘What about property?’ you might ask. Well, we don’t have an income-generating investment property. Our only property is the home we live in, which is fully paid (yes, we’re debt-free). We plan to stay here indefinitely, so we consider it a lifestyle expense, or rather an unproductive asset. More on this in Why We Do Not Consider Our Home an Asset.
Ultimately, everyone’s situation is unique, so you will probably build a different FIRE from us. Your risk tolerance will also affect your game plan. Our strategy has worked well for us so far, but we expect to make adjustments as we go through retirement. Life is full of surprises, so we must be ready for change at all times. My motto is: Always be prepared for the worst and have a contingency plan for every possible disaster.
I hope this article has helped you on your FIRE journey. Do share your experience or strategy with us in the comment section below. Wishing you success!
Sources:
- 3 things you need to know about the 4% rule: https://money.cnn.com/2018/02/07/retirement/4-percent-rule/index.html
- The 4% Rule And The Search For A Safe Withdrawal Rate: https://www.forbes.com/sites/wadepfau/2016/04/19/the-4-rule-and-the-search-for-a-safe-withdrawal-rate/?sh=152499ea5a10
- How Much Is Enough?: https://www.fa-mag.com/news/how-much-is-enough-10496.html
- March 2012 issue of The Kitces Report on “20 Years of Safe Withdrawal Rate Research — Expanding the Framework of Safe Withdrawal Rates”: https://www.kitces.com/march-2012-issue-of-the-kitces-report-expanding-the-framework-of-safe-withdrawal-rates/
- Understanding Sequence Of Return Risk – Safe Withdrawal Rates, Bear Market Crashes, And Bad Decades: https://www.kitces.com/blog/understanding-sequence-of-return-risk-safe-withdrawal-rates-bear-market-crashes-and-bad-decades/
If you’re new to the FIRE movement, you may want to read Mr Wow’s article on the 7 levels of wealth. Believe it or not, financial independence is only the fifth level!
Spending some time to think about your money values and why you want to achieve FIRE will also help you stay on course. If you’re married, you also need to make sure that you’re on the same financial page as your spouse.
You may also like: Unlock Your Future: 5 Reasons to Plan for Early Retirement | The Big Reveal: Our Net Worth Exposed
“Lower Withdrawal Rate: Instead of drawing down 4% on our portfolio each year, we withdraw just 3%, sometimes less (principal untouched as our dividends and coupons yield more than 3%).”
I like it – I plan to do the same thing and just spend what my portfolio throws off at least through the period of getting through the sequence of return risk.
Great minds! 🙌
Our low withdrawal rate definitely helps us sleep well at night.
Having experienced the Covid-19 crash and subsequent dividend cuts, we can safely say that we made the right call to accumulate more before retiring. We’re quietly confident that our portfolio is resilient to market volatility.
Cheers to your success! 🌈