The Four-Percent Rule Explained

Many working people dream of retiring early to spend more time on travel, friends, and family. Dyed-in-the-wool fans of this concept drive the financial independence, retire early (FIRE) movement.

In order to retire early at the age of 55, 50, 45, or even 40 years old, it is essential that you accumulate enough savings. But figuring out exactly how much money you need to save can be complicated. That is where the four-percent rule comes in.

Where did the four-percent rule come from?

The rule of thumb is based on the so-called Trinity Study conducted in 1998. Three leading professors at the Trinity University in San Antonio found that the capital invested in a mixed portfolio of stocks and bonds is very likely to last you for at least 30 years if you withdraw from it at the rate of three to four percent per year. The chances of success are notably lower if your rate of withdrawal is higher than that.

What is the four-percent rule?

There are varying interpretations of the four-percent rule. One of the most common versions is that after you have saved up a certain amount of money, you can withdraw four percent of the capital every year for the next 30 years without exhausting your savings. The amount of money you have to save must be at least 25 times higher than your annual spending. Additionally, you also need to earn a high enough return on your savings in the form of capital gains, dividends, and interest. Some versions of the four-percent rule assume that you will live off your savings for much longer than 30 years. Hypothetically, you would never actually have to use your original savings as long as the returns you earn on that capital are at least four percent per year.

In order to accommodate changes in purchasing power as well, you can adjust your annual expenses to account for inflation. If the annual inflation rate in a given year is 2 percent, for example, then you would have to increase the effective amount you withdraw by two percent in the following year. You would have to earn a return of 4.08 percent in order to cover the higher withdrawal without touching your original capital.

The interactive FIRE calculator on moneyland.ch makes it easy to find out how much money you need in order to be financially independent, and how much money you have to save every month in order to reach that goal.

How can I save enough money?

If you want to reach full financial independence, then you will have to save and invest a substantial part of your income – 40 to 50 percent of your available income in many cases. That often is not possible without adjusting your lifestyle and cutting out “unnecessary” consumer spending – such as restaurant dining and shopping. The reason why people who follow FIRE philosophies are often referred to as frugalists is exactly because they promote a frugal lifestyle and more conscious consumer habits.

Reducing your own spending requires discipline and careful budgeting. If you are absolutely serious about retiring early, you have to find out which costs you could potentially be saving money on, and use up this savings potential. That applies to major expenses like housing, health insurance, and groceries in particular. Having an exact overview of all your expenses is recommended, and can also be helpful when creating your emergency fund, for example.

It is important not to be too extreme in the financial limits you set for yourself. You will not do yourself favors by neglecting important personal needs, and setting unrealistic goals can endanger the long-term success of your financial independence goals. It is important to make a balanced plan that you can consistently stick with over many years.

How should I invest my savings?

Simply placing your savings in a private account or savings account will not bring the desired results. While the risk of losing money might be small, it generally is not possible to earn an annual return of around four percent.

A well-diversified investment in the stock market – using exchange-traded funds (ETFs), for example – is generally a more promising option. While the risk of losing money is higher, over the long term the performance is typically better than that of bank accounts. Important: You should keep your investment expenses as low as possible, as they detract from your returns. The online trading comparison on moneyland.ch makes it easy to find an affordable bank for your investment needs.

If you had invested your money in the Swiss Performance Index (SPI) between 2003 and 2023, your average annual return would have been 7.54 percent, without accounting for bank and investment product fees. That return, shown by the moneyland.ch historical return calculator, is higher than four percent. If you had put your money in an average Swiss savings account over that same term, you would have earned an annual return of just 0.29 percent. Both of those figures do not account for inflation.

What are the problems with the four-percent rule?

The four-percent rule offers a good reference point, but like many hypothetical formulas, it has its weaknesses. There are several issues:

• Volatility: The stock market is volatile. There is no guarantee that you will earn a return of at least four percent per year, even with diversified investments. High average returns are usually only achieved over long periods. The actual annual returns can be low or even negative in some years, or even for many years at a time. That can pose a problem, especially at the beginning of the withdrawal phase. If your investments lose value, you run the risk of using more capital than your returns allow for. This is called the sequence of return risk.
• Unforeseeable events: The amount of capital you need to save up, as per the four-percent rule, is based on your normal annual spending. But unforeseeable events can result in your actual expenses being higher in some years. In order to avoid having to use your original savings, you should make sure to include a wide margin above your anticipated expenses. It is also helpful to have an additional emergency fund.
• Timeframes: The original Trinity study only accounted for a time frame of up to 30 years. But if you want to retire earlier, you may well need to withdraw from your savings for more than 30 years.

More on this topic:
The 50-30-20 rule explained
How to invest money in Switzerland
Perpetual annuity calculator