Does the 4% Retirement Spending Rule Still Hold Up—And Where Do Rentals Fit in?

by | BiggerPockets.com

Personal finance nerds (like myself) spend an inordinate amount of time thinking about retirement.

How much do you need? How can you ensure that you don’t run out of money in retirement? What’s the fastest way to get there, and does fast also mean safe?

For the last 20 years, the 4% rule (a.k.a. the 25X rule) has been something of an industry standard. At the very least, it’s been a shorthand to use as a reference point. But for all its simplicity, how “true” is it? Does it leave room for shortcuts?

Is it even still relevant in today’s economic environment? And where do rentals fit in?

But we’re getting ahead of ourselves. Let’s start at the beginning.

How Did the 4% Rule Come About?

Back in the ‘90s, financial advisor Bill Bengen introduced the idea of the “4% rule.” It’s simple enough: A retiree can afford to withdraw about 4% of their nest egg each year, if they want it to last them 30 years. Bengen proposed this rule after analyzing historical stock and bond market returns and found a 4% withdrawal rate to be safe for retirees.

On the simplest level, it makes sense. If your stock portfolio rises in value by an historically-reasonable 7%, and you subtract out 2% of that for inflation, that leaves a “real” return of 5%. You take 4%, and voila! Your stock portfolio’s value actually rose by 1% over the course of the year, even though you sold off some of it.

The other way of thinking about this rule is by its other name, the 25X rule. It dictates that investors will need a nest egg of 25 times their annual spending if they want to live on 4% of it each year. Thus, if you want to withdraw $40,000/year as income, you’ll need a $1,000,000 nest egg.

How Does the 4% Rule Hold up in Today’s World?

First, consider the simplest problem at all: What if you live for more than 30 years after retiring?

Americans who reach 60 can expect to live into their 80s—and increasingly live into their 90s or even become centenarians. So, this 30-year timeline may not leave every 60-year-old jumping for joy.

Related: 7 Achievable Steps to Reach 7-Figure Retirement Savings

And hang on a second—does it even guarantee you 30 years of income?

Of course not. Aside from the possibility that you invested money in the next Enron, the market could crash right after you retire. One T. Rowe Price study found that, moving forward, there’s 90% probability that retirees following the 4% rule won’t run out of money in 30 years. This means that a troubling 10% of the time, retirees could expect to run out of money.

Bonds, interest rates, market crashes, oh my!

Some of your retirement portfolio is probably made up of bonds, not stocks. And in the ‘90s, when Bengen proposed this rule, interest rates were high and bonds paid well.

In a low-interest environment (like we’ve seen in this century), investors can’t expect much in the way of returns from them. They also have a fixed lifespan and run out eventually. Still, retirees often still rely on them because of their greater reliability over stocks.

That T. Rowe Price study above was based on a 60% stocks/40% bonds allocation, just like Bengen’s original proposed rule allocation. But not everyone uses this asset allocation. What if you retire with half of your portfolio in stocks and half in bonds? A Vanguard study found that over 35 years, the rule only worked 71% of the time under these conditions.

Here’s the other big risk with the 4% rule: what if the market crashes right after you retire? If you’re only pulling money out when a market crashes and not putting any money back in, then it’s all downside for you. You lose money on the crash, but don’t make any money by investing in the recovery.

Sure, the market will eventually recover, but between now and then, you will have had to draw down significantly on your balance. When the recovery comes, your remaining portfolio will be much smaller, leaving less to regain lost ground with.

For all that, financial planner Michael Kitces points out that over the last 150 years, there has not been a 30-year period when someone following the 4% rule would have run out of money.

The Wild Card: How Rentals Change the Math

Here’s where things get interesting. What happens when rentals enter the mix?

In our earlier example, we decided we wanted $40,000 in income post-retirement in addition to Social Security, which would mean a $1,000,000 nest egg. That comes to $3,333/month.

Our imaginary friend Michelle invests $250,000 in a fourplex that rents for $3,600/month. After expenses, let’s say she earns $1,800/month on it.

Now she only needs another $1,533/month, or $18,396/year, from her stock portfolio. That means a nest egg of $459,900.

See what happened there? Michelle’s total sum needed just dropped from $1,000,000 to $709,900 ($250,000 for the fourplex, $459,900 for stocks). She just trimmed nearly $300,000 off her total necessary assets!

great-deal

The Balance Between Rentals and Stocks

Sometimes stock markets crash. Sometimes rental properties hit their owners with several expenses at once. But that’s the beauty of diversification—those two events almost always remain unrelated.

During the Great Recession, U.S. stocks crashed by around 30%, and real estate values dropped similarly. But rents did not drop. Why? Because so many homeowners became renters that the demand for rental housing actually increased.

Smart landlords set aside money for repairs, vacancy rate, CapEx, etc. into a property fund each month, so that when a turnover or a $5,000 roof bill comes along, they’re prepared for it. But imagine that several turnovers and a huge roof bill happen to come along all at once. A retiree can draw a little extra from their stock portfolio that month to cover the difference.

Related: Want to Retire Early? Sorry, But Much of Your Net Worth May Not Help

When landlords see strong performance from their rentals, they can always invest extra in their stock portfolios. Likewise, when their stock portfolio is suffering, landlords might postpone a property upgrade they’d been considering and lean more heavily on their rental income.

And there’s that little matter of inflation; rents rise alongside (or surpass) inflation. That makes rentals an excellent hedge against it.

Diversification is a beautiful thing.

The Exponential Impact of Spending

Consider this side of the 25X rule: It highlights just how costly each extra dollar of spending is for your bottom line.

For every $100/month that you spend, you’ll need an extra $30,000 in your nest egg, according to the 25X rule. Seriously, $100/month is $1,200/year, which multiplied by 25 is $30,000.

Is your cable bill really worth having to invest another $30,000? What about that latte habit?

At the risk of sounding like a nag, if you cut that spending now, you can invest it and reach your nest egg goals much, much faster. For a tough (but rewarding!) challenge, try living on half your income and investing the rest.

Eyes on the Prize: Financial Independence

For me, the point of investing is clear and simple: replacing active income with passive income. On the day when my passive income can cover my expenses, I’ll reach financial independence, and every day that I work thereafter will be a choice.

Any discussion of withdrawal rates (e.g. the 4% rule) rests on an underlying fear. At its heart, the discussion revolves around “how much of my portfolio can I sell in a given year, with a reasonably low risk of running out of money?”

I don’t want to worry about running out of money. I want my portfolio to keep growing even after I retire. And to do that, all I must do is focus on building passive income. Rental properties, stock dividends, and bonds all offer it.

You can still sell off stocks in retirement, of course. Selling off 2%, 3%, even 4% will almost certainly leave you in fine shape. But if you can keep that number under 3-4%, and replace a healthy chunk of your monthly income with rents instead, your nest egg will almost certainly grow rather than shrink.

How is your retirement investing coming along? What tips do you have to get there even faster?

Leave your thoughts and questions below!

About Author

Brian Davis

Brian is a rental investor with 15 income properties, who provides free video training to help everyday people start earning passive income at SnapLandlord.com. He's also the co-founder of SparkRental.com, which provides free services & education for landlords. His rental management is almost completely automated by now, allowing him to travel the world (his current home base: Abu Dhabi).

18 Comments

  1. Chad Carson

    Brian, this is an excellent presentation of the 4% rule and real estate! I count myself in the personal finance nerd category like you and think (and write about) this stuff way too much:)

    I completely agree that rental income changes the math. It’s like a pension income that puts a relatively secure floor on your retirement income. The stock portfolio is then for extra growth and diversification. Like you said, when rentals do great, buy more stocks/bonds. When stocks/bonds do great, buy more real estate.

    In addition to rentals and stocks, I like private note investing instead of bonds. I’m curious if that play in at all to your personal diversifcation?

    • Brian Davis

      Thanks Chad! By the way I discovered your blog recently (via a guest post you wrote for BudgetsAreSexy), I’ve been thoroughly enjoying it as a fellow personal finance nerd 🙂
      I have done some private note investing in the past, and had good experiences, although I’m not currently. Right now my funds are tied up in expanding my business.

  2. Mark Spidell

    Nice article! One dynamic of long term rentals is the potential of housing market changes and how it might impact retirement planning. I think most people can agree that it is harder to find cash flowing properties in a lot of markets compared to a few years back, so investors have to stay dynamic with there real estate diversification. Consider these scenarios:

    1. After 20 years, your properties might have appreciated so much that you are renting properties that no longer have a very good rent to value ratio. Perhaps transition into muni bonds depending on your tax situation or transition to a different market.
    2. Let’s say your market disappears. Imagine if you started building a rental portfolio of income properties in Detroit in the mid sixties with a 30 year horizon! Hopefully adjustments are made over time vs. being a frog in boiling water!

    • Brian Davis

      Very true that markets constantly evolve, and you have to keep an eye on them to decide if the time has come to sell. Rentals tend to do quite well over a long time horizon though, appreciating in value while rents rise with inflation. Still, as you point out, “usually” is not the same as “always”.

  3. Ted Carter

    Good article. Over the years I have read so much about the 4% rule. The simple solution for me is remove money from your IRA when the market is up – go TRUMP – and less in year like 2008 when the market is down. Maybe it is simple as that ?????.
    The thing about stocks is the price, one day it is up, the next day down and you have absolutely no control. Ride it out is the only choice you have. With the rentals you do have a level of control – even in a no growth area like mine – the income is steady – you can ride by and see it – touchy feele thing – no big up and downs, oh sure some times we have issues with renters but what LL doesn’t.

  4. Susan Maneck

    This is a good reminder not to think in terms of either/or but *both.* One thing I would add to this is except in the case of a major crash which hurts both sources of income, avoid taking out Social Security until you are 70. It increases by 8% every year you leave it alone. One other thing that should be probably kept in mind is that real estate investments aren’t all that passive and if we live long enough there will likely be a time when we will need to dispose of our portfolios. One solution to insuring that there will be enough money on into our late eighties or nineties is to purchase a Qualified Longevity Annuity. This can be done inside a retirement fund but is not subject to required minimum distribution rules until your contract actually begins to pay out, usually when you are 80 or 85. Let’s say you invest 100K into it when you 65. At 85 it will produce over $2800 in income, probably enough to replace that rental income. And the nice part of it is that it leaves you free to spend the rest of your portfolio without worrying about running out.

    • Brian Davis

      Great point Susan about postponing Social Security as long as possible! Likewise that retirees won’t always be able to manage their own properties – I’m a huge believer that investors need to calculate property management fees into their returns and cash flow from Day 1, because sooner or later the time will come when they no longer want to manage their own properties.

    • Please be very careful about buying any type of Annuity, 98% are over priced with commissions and there are always better ways to achieve the same goal. Putting a tax deferred vehicle inside a retirement plan is never good.

  5. John Murray

    Today I turned 59 1/2 plus 1 day. I have about 60K in passive rent profit and gaining 12% per year in leverage on $3M in SFH rentals. Today I have access to another $1.5M without penalty. . In 2 1/2 years the feds will send me another $2.5K per month in SSI on top of my $2.2K defined benefit pension . America is a great place to succeed, you just have to work hard. If an electrician can do this anyone can with hard work and intelligence.

  6. Excellent article! This point is well-taken. I’ve always been interested in tackling the 4% rule and putting it along side rental properties. In my case, I’ve taken most of my S&P 500 index and turned it into rental properties that are paid off and making 8% I like to call it the 8% rule, as that is what I estimate I’m getting. In that case, it only takes $500,000 of real estate to do what $1M does under the 4% safe withdrawal rate. Retire twice as fast, or live twice as large.

    But there is always a case for diversification.

    • Brian Davis

      Awesome Rich! Glad to hear your rentals are working so well for you. I agree, rentals definitely help you retire much faster. But as you mentioned, diversification is crucial too, which is why I also keep stocks as part of a balanced investment portfolio.

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