The Simple and Controversial Math behind Financial Independence: The 4% Rule

Okay enough is enough. You’re tired of me shouting out these amazing things like EARLY RETIREMENT and FINANCIAL INDEPENDENCE and FREEDOM and PIZZA. Okay, maybe not the last one. I’m just hungry while writing this.

So at this point you’re on board for giving this FI thing a chance. But there is obviously a super complicated mathematical equation that required finance wizards and financial advisor gurus to get you there. And I thought the same thing. There was no way that people could manage their own money and get to where they wanted to go. I mean most people are in charge of their own money, and look how most of the country’s financial situation is. BUT, thanks to a couple really, really smart people, they’ve shown us that it’s not hard at all. It’s actually just sticking to the 4% Rule, also known as the SWR (Safe Withdrawal Rate). The safe withdrawal rate is the maximum amount that you can spend per year without ever running out of money or diminishing your nest egg.

If you would ask the average person just walking down the street how much money they needed to retire, most would just say a random high number that they thought of. When I asked my own friends this question, I received answers ranging from $3-10 million. But the real answer might surprise you.

The Origin of this Model:

There was a study done at Trinity University back in the late 90s. Essentially three professors used historical data from market performance from 1925-2009. They used a portfolio of 50% S&P 500 and 50% corporate bonds. And they mapped out the thousands and thousands of possibilities of what could happen to a person’s portfolio over 30 years. And what did they find out? That a person who used a 4% withdrawal rate had a 95% chance of success of not running out of money.

Now let’s go over the ground rules. I am going to give you a common and basic situation to portray this scenario, and THEN we will talk about all of the other factors that can obviously affect things.

The Equation of this Model:

The equation goes as follows:

  • Yearly Expenditures x 25 = The Nest Egg
  • The Nest Egg + Invested in Index Funds and Bonds = 7% Avg Annual Return
  • 7% Avg Annual Return = 3% for Inflation + 4% for your Yearly Expenditures
  • In Conclusion: Nest Egg +7% Returns – 3% Inflation – 4% Yearly Expenditures = Nest Egg Forever


The example is as follows:

  1. You spend $40,000 a year to live your life.
  2. $40,000 x 25 = $1,000,000 for a Nest Egg
  3. $1,000,000 + 7% Return = $1,070,000 for your Yearly Portfolio
  4. $70,000,000 Avg Annual Return = $30,000 for Inflation + $40,000 for your Yearly Expenditures
  5. In conclusion $1,000,000 + $70,000 Return – $30,000 Inflation – $40,000 Yearly Expenditures = $1,000,000 same nest egg.

So what does this mean? If you can live off of, $40,000 a year then you need to save $1 million, you need $80,000 then save $2 million. And if you are really quiet, you can hear the thousands of online finance police people typing their furious responses. So let’s go over some of the rules.

The Rules of this Model:

  1. You should only be investing in Index Funds and Bonds. Many people in the FI community argue over what the ratio should be, but since most of the math here stems from the Trinity Study, let’s just suggest that you should be “retiring” with 50% Index Funds and 50% Bonds
  2. Only invest in Index Funds. Owning shares of an Index Fund is like owning a Mutual Fund that matches the market. This means a few big things:
    1. The fund just matches what the market is doing, there is no one actively managing the fund
    2. The cost is extremely low, which can keep thousands of dollars in your nest egg
    3. You are essentially owning small portions of every publicly traded company (if you do a total stock market fund) or a small portion of every publicly traded bond (if you do a total bond market fund). This creates an extremely diverse portfolio.
    4. This means you are essentially investing in the economy and not one company. And I trust the US economy a lot more than I trust one company. Think of how many thousands of companies have come and gone. While the US economy fluctuates, it always bounces back and has always been crawling upwards.
    5. You don’t have to worry about buying and selling every time something happens with a certain company or market.
    6. You have a strong stomach and ride out the inevitable (and very normal) cycles of the US economy. This includes market crashes.
  3. You need to stick to 4% and not to a certain dollar amount.

The Assumptions of this Model:

  1. You will have the same yearly spending every year
  2. You will not make any money from a side job or hobby
  3. You will not collect any money from Social Security
  4. It does not take into account major economic events, like a major market crash
  5. You will not want to diminish your nest egg, so you only live off of the interest

The Problems with this Model:

  1. The stock market is unpredictable. The market can go up and down. So some years will be better than others. Most people in the FI community will ONLY invest in index funds. This is because no matter, that market rebounds. Most FI members will actually double down during low points, as they see this as a “sale” for index funds. The market has always recovered, but not every year will be pretty.
  2. Inflation is also unpredictable. In the model we use an average rate of 3%, but of course who knows if there will be a period of hyperinflation. There could be food or oil shortages that could exponentially increase the price of some of our most basic needs.
  3. It assumes that your spending will not go up exponentially. If you base your yearly spending on what is cost you to live in your early 20s, chances are that is not going to be correct. While it is great that you can live super cheap right now, you may need to adjust your yearly spending to something higher if in the future you plan to make a large purchase, move to an area with a higher cost of living, or start a family.

The Benefits that Aren’t Even Included in this Model:

  1. Chances are that if you’re “retiring early”, you will be either getting involved in a side gig or a hobby that can create income. You’d be amazed at how easy it is to make some extra money once you are doing something for passion and have the time for it, without being so concerned about where the money is going to come from.
  2. Hopefully, most of us will still be getting something from Social Security (and for those of us still lucky enough, have a pension)
  3. Many of us substitute our spending habits during periods of change. If the market is having a bad year, many of us can shop at a cheaper grocer, eat out less, vacation closer to home, or use the car less. You are not held to the yearly expense that you chose for the model. It is recommended that you adjust your spending based on your portfolio’s return.
  4. Some years your Nest Egg will have a higher than 7% return.
  5. Some years you will not spend all of your return, which will be reinvested back into the Nest Egg to make the principal amount even higher.
  6. The average tendency is that we spend less the older that we get.
  7. Even if we “fail” to only live on the interest, you still have this massive nest egg. This gives you plenty of flexibility. This model assumes that you want to pass your nest egg on instead of maintaining it.

Now it is Time to Model:

So there you have it. While there is a decent amount of criticism on this model, it is only justified if you only look blindly at the equation from an academic perspective. To see why there is a strong case for the model, you need to see all of the non-quantitative factors that go into it. This is a great base to start your journey to financial independence. Your yearly plan will need revised as your life and the world around us changes. But when you inject your life with other aspects of FI (frugal living, smart investing, side hustles, etc.) you’re life after FI becomes even more possible.

Check Out Some of My Favorite 4% Rule Articles:

Mr. Money Mustache

1500 Days

Millennial Revolution

The Mad Fientist

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About Dave 12 Articles
I'm the Common Cents Millennial and I am here to change how you think about your finances. Follow me as I struggle with student debt, side hustling, budgeting, lowering my expenses, and my path to early retirement. My goal is to go from $150k in student debt to early retirement in 15 years or less!

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