Risk of using 4% rule for your FIRE journey

When it comes to saving for retirement, you face several risks—market fluctuations, rising living costs, risk of outliving your savings, etc. However, most investors often overlook sequence risk. It refers to the potential danger of experiencing negative investment returns early in retirement. Such negative returns, combined with periodic withdrawals, lowers the amount of capital available to grow during good market conditions. This can significantly affect the longevity of your retirement portfolio. If you are not adding or withdrawing from your portfolio, then the sequence in which the returns occur does not have any impact on the final portfolio value. However, after retirement, we have to withdraw from our portfolio every month. In that case, the sequence of returns does impact your portfolio.

Consider that the equity markets are in a bear phase during the early phase of your retirement. Then, your withdrawals will be akin to exiting your equity holdings at a loss. And when the markets recover later, you get lower absolute profits because the retirement fund is now smaller due to the withdrawals. On the flip side, if the equity markets are in a bullish phase early on in your retirement, the portfolio will not be affected as much by the withdrawals as the returns will be better. As per a study, every investor will benefit from the 4% rule—the safe withdrawal rate which minimises the risk of you outliving your savings. 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 in tandem with the rise in inflation. If you follow this approach, your retirement savings should last at least 30 years or beyond .

However, there are some limitations to the rule. First, the study was conducted in the US market and there is not enough evidence to conclude 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. Past returns might not prove to be a good indicator of expected future returns. The success rate of using 4% rule in India is 81% for a 25-year retirement period. This reduces to 62% for 35 years.

A simple approach to mitigate sequence risk is the dynamic spending rate. This strategy involves adjusting your annual withdrawal based on your portfolio’s performance and the remaining balance. In any particular year that the market performs well, you increase your withdrawals. If the market underperforms, you adjust your withdrawals downward that year. This way you can minimise 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 favourable sequences, spending increases over time to utilize the extra retirement assets, and during unfavourable sequences, spending remains conservative to ensure sustainability.

Another dynamic spending approach is to use some sort of guard rails. Here, spending should be reduced if ongoing withdrawals as a percentage of the portfolio rise above 5% (because spending is outpacing portfolio growth), while spending is increased if withdrawal rates dropped below 3% (because portfolio growth is outpacing spending growth). The outcome changes dynamically with the potential for spending increasing if the sequence turns out to be more favourable and the potential for lower withdrawals if the sequence is unfavourable. Research has shown that using some sort of dynamic spending can increase the success rate of investors outliving their portfolio by as much as 10-20%. By understanding sequence risk and implementing appropriate mitigation techniques, you can enhance the security and success of your ‘financial independence, retire early’ (FIRE) journey.

Vivek Sharma is the director and head—investments, Estee Advisors—Gulaq.