Introduction

Worried about an early retirement based on the Four Percent Rule? Might the 4% Rule work because of natural backstops most early retirees enjoy? 

The 4% Rule

The 4% Rule is a rule of thumb developed by the FI community. For example, JL Collins writes extensively about the 4% Rule in Chapter 29 of his classic book The Simple Path to Wealth.

Boiled down, the rule of thumb states that an investor can retire when he or she (or a couple) has 25 times their annual expenses invested in financial assets (equities and bonds). They would then spend down 4% of their wealth annually in retirement. The first year’s withdrawal forms a baseline and is increased annually for inflation.

The idea behind the 4% Rule is that the retiree would have a very strong chance of funding retirement expenses and never running out of money in retirement. As a result, some refer to 4% as a safe withdrawal rate. 

Here’s how it could look:

Maury is 50. He has $1M saved in financial assets. He can spend $40,000 in the first year of retirement. If inflation is 3% at the end of his first year of retirement, he increases his withdrawal by 3% ($1,200) to $41,200 for the second year of retirement.

The 4% Rule has a nice elegance to it. Most investors aim for a greater than 4% return. In theory, with a 5% return every year, the 4% Rule would never fail a retiree. If you spend approximately 4% annually, and earn approximately 5% annually, you have, in theory, created a perpetual money making machine and guaranteed success in retirement.

The theory is great. But in practice we know that investors are subject to ups and downs, gains and losses. What happens if there is a large dip in equity and/or bond prices during the first year or two of retirement? What if there are several down years in a row during retirement? 

As a result of these risks, and stock market highs in late 2021, some are worried that the 4% Rule is too generous for many retirees. Christine Benz discussed her concerns on a recent episode of the Earn and Invest podcast. 

This post adds a wrinkle to the discussion: the four backstops to the 4% Rule for early retirees. What if worries about the adequacy of the 4% Rule for early retirees can be addressed by factors outside of the 4% Rule safe withdrawal rate? And what if those factors quite naturally occur for early retirees?  

Resources for the Four Percent Rule

These are links to articles addressing the 4% Rule and safe withdrawal rates

Cooley, Hubbard, and Waltz (Trinity University) 2011

Bengen 1994

Below I discuss what I believe to be the four natural backstops to the 4% Rule. 

Spending

A 4 percent spending rate in retirement is not preordained from on-high. Spending in retirement can be adjusted. Those adjustments can take on two flavors.

The first flavor are defensive spending reductions.  As Michael Kitces observed on an episode of The Bigger Pockets Money podcast, retirees will not blindly spend 4 percent annually without making adjustments in down stock markets.

See that the stock market is down 10 percent this month? Okay, take a domestic vacation for 6 days instead of an international vacation for 9 days. Buy a used car instead of a new car. Scale down and/or delay the kitchen remodel.

There are levers early retirees can pull that can help compensate for declines in financial assets while not too radically altering quality of life. 

The second flavor is, from a financial perspective, even better. As early retirees age, there will be natural reductions in spending. How many 80 year-olds decide to take a 12 hour flight to the tropics for the first time? There is a natural reduction in energy and interest in certain kinds of spending as one ages. It is likely that many retirees will experience very natural declines in expenses as they age. 

Social Security

For the early retiree under 62 years old, the 4% Rule must disregard Social Security. Why? Because Social Security does not pay until age 62, and many in the financial independence community delay Social Security payments beyond age 62, perhaps all the way to age 70 (to increase the annual payment).

Here is an example of how that works.

Melinda is 55. She has accumulated $1.5M in financial assets and can live on $60,000 per year. If she retires at age 55 and lives off $60,000 a year increased annually for inflation, the only financial resources she has are her financial assets (what I refer to as her 4% assets). She cannot live off Social Security payments until age 62, and may choose to defer receiving Social Security up to age 70. 

If Melinda defers Social Security until age 70, and receives $2,500 per month at age 70 from Social Security, her 4% assets now do not need to generate the full 4% once she turns 70, since Social Security will pay her $30,000 a year at age 70.

In theory, under the 4% Rule, Melinda’s Social Security is play money. Melinda funds her lifestyle with withdrawals from her financial assets, and now she’s getting additional Social Security payments. But, if her portfolio is struggling to produce the amount Melinda needs to live off of, Social Security payments provide a backstop and can help make up the difference. 

You might think “but wait a minute, didn’t Melinda significantly lower her Social Security benefits by retiring early by conventional standards? The answer is likely no, as I described in more detail in my post on early retirement and Social Security. First, only the 35 highest years of earnings count for Social Security benefits. At age 55 is it possible Melinda has 35 years of work in. 

Second, and more importantly, Social Security benefits are progressive based on “bend points.” The first approximately $12,000 of average annual earnings are replaced by Social Security at a 90 percent rate. The next approximately $62,000 of average annual earnings are replaced by Social Security at a 32 percent rate, and remaining annual earnings are replaced at a 15 percent rate. This is a fancy way of saying that reducing later earnings, for many workers, will sacrifice Social Security benefits at a 15 percent, or maybe a 32 percent, replacement rate. Even early retirees are likely to have secured all of their 90 percent replacement bend point and a significant amount of their 32 percent replacement bend point. 

I previously wrote the following example:

Chuck is 55 years old and has 32 years of earnings recorded with Social Security. Those earnings, adjusted for inflation by Social Security, total $2,800,000. Divided by 35, they average $80,000. This means Chuck has filled the 90 percent replacement bend point (up to $12,288) and filled the 32 percent replacement bend point (from $12,288 to $74,064) of average annual earnings. If Chuck continues to work, his wages will be replaced at a 15 percent replacement rate by Social Security. 

An additional year of work for Chuck at a $130,000 salary netted Chuck only $557 more in annual Social Security benefits at full retirement age! 

Real Estate

Most early retirees own their own primary residence, usually with either significant equity or no mortgage. That primary residence can be a backstop to the 4% Rule.

For example, a retiree might live in a 2,000 square foot, $500,000 home with no mortgage. During their retirement, they might decide they don’t want to maintain such a large home, so they sell the 2,000 square foot home and move into a 1,000 square foot condominium at a cost of $350,000. The $150,000 difference in sale prices can become a financial asset to backstop 4% Rule assets and help the retiree succeed financially.

Alternatively, the early retiree could sell the $500,000 home and move into a smaller apartment with a $2,000 per month rent. While the retiree has increased their expenses, they also have created $500,000 worth of financial wealth to help pay that rent and fund their other expenses.

A third option is a reverse mortgage where the retiree stays in their primary residence but gets equity out of the home from a bank. 

Real estate can serve as a natural backstop to help ensure retirees have financial security and success.

Death

It’s wet blanket time. You may be considering a 30, 40, or 50 year retirement. Unfortunately, there is a good chance that you will not live that long. Sadly, not all early retirees have a long retirement. 

As demonstrated in these tables, there is a real chance that an early retiree will not live for 25 or 30 years. That factors into whether or not the 4% Rule will work for an early retiree. 

Let’s consider a 55 year old considering early retirement using the 4% Rule. He believes that he will live 30 more years and there is a 95% chance that his assets will last 30 years. He believes that the 4% Rule has a 5% chance of failing him. Further, assume that he believes there is a 30% chance that he will die prior to age 85.

His own potential death reduces the chance that the 4% Rule will fail. Remember, failure requires that he has to both run out of assets and live long enough to run out of assets. By his estimation, the odds that both events will occur are just 3.5 percent. To figure this estimated probability, multiply the probability that he will run out of assets (5%) by the probability that he will live long enough to run out assets (70%). 

A not insignificant number of early retirees will have an early retirement that lasts (sadly) only 10 years, 15 years, or 20 years. That (again, sadly) backstops the 4% Rule. 

Early Retirees vs. Conventional Retirees

I’ve contended that early retirees have four natural backstops to the 4% Rule. What about more conventional retirees? I’ll define a “conventional retiree” as one who collects Social Security soon after retiring. 

I believe conventional retirees enjoy three of the four backstops. Sadly, they “enjoy” the mortality backstop to a greater degree than early retirees. 

Conventional retirees retiring on Social Security do not enjoy Social Security as a backstop to the 4% Rule in most cases. Here’s an example:

Robert is age 65 and is planning to retire on financial assets and Social Security. He will collect $36,000 a year in Social Security and will spend a total of $76,000 a year. To facilitate this, he will initially withdraw $40,000 from his $1M portfolio.

In Robert’s case, Social Security is not a backstop to the 4% Rule. Rather, the 4% Rule is simply one of two necessary but not sufficient sources of funds for his retirement. A failure of the 4% Rule in Robert’s case would not be backstopped by Social Security. 

Conclusion

While there are no guarantees when it comes to safe withdrawal rates in retirement and the 4% Rule, it is possible that many early retirees will succeed with the 4% Rule, for two reasons. First, the 4% Rule may, by itself, be successful for many early retirees. The second reason is that even if the 4% Rule fails, there are four natural backstops in place for many early retirees that can step in and help retirees obtain financial success even if the 4% Rule fails on its own.

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.

UPDATE October 20, 2023: This post has been updated for the 2024 Social Security numbers.

I can’t retire early! I’ll destroy my Social Security!

Is that true? What happens to Social Security benefits when retirees retire early? Are significantly reduced Social Security benefits a drawback of the financial independence retire early (FIRE) movement? 

Below I explore how Social Security benefits are computed and the effects of retiring early on Social Security.

Social Security Earnings

Form W-2 reports to the government one’s earnings during the year. For the self-employed, the Schedule SE performs this function. The Social Security Administration tracks those earnings. 

Only a limited amount of earnings every year count as Social Security earnings. There is an annual maximum on the amount of earnings that can go on one’s Social Security record, regardless of the number of jobs one has. For 2024, the Social Security cap is $168,600. The cap is increased most years for inflation. Payroll taxes for Social Security (FICA for W-2 workers, self-employment taxes for the self-employed) are not due on earnings above the cap.

Social Security Benefits

A few very general rules need to be established as we consider the amount Social Security pays.

1. Only the highest 35 years of earnings during one’s working years count in determining Social Security benefits.

2. For most Americans reading this, full retirement age is 67. This means a person can collect his or her “full” Social Security benefits at age 67.

3. Social Security benefits can be collected as early as age 62 and can be deferred as late as age 70. Collecting early reduces annual benefits (by roughly 5 to 7 percent per year) and collecting late increases benefits (by 8 percent per year).

4. Annual earnings used in determining benefits are inflation adjusted through age 59. Earnings earned at age 60 and later are not inflation adjusted for purposes of computing Social Security benefits. 

5. Very roughly speaking, the annual benefit is computed as follows: accumulated earnings (computed based on the rules described above) in the high 35 years are summed and then divided by 35. The resulting average annual earnings are applied against the Social Security “brackets” or “bend points.” Up to $14,088 (using 2024 numbers) of computed average annual earnings is replaced by Social Security at a 90% rate. The next $70,848 of average annual earnings are replaced at a 32% rate. Any additional amount of average annual earnings is replaced at a 15% replacement rate. The bend points are adjusted for inflation.

One need not be an expert on Social Security to see directionally how early retirement might impact Social Security benefits. Because of the progressive nature of Social Security benefits, leaving work early (by conventional standards) tends to reduce benefits less than one might initially expect. Additional earnings later in life tend to only slightly increase Social Security benefits.  

Early Retirement Social Security Example

Here’s an example to help us understand the impact of an early retirement on Social Security benefits. 

Chuck is 55 years old and has 32 years of earnings recorded with Social Security. Those earnings, adjusted (thus, nominally increased) for inflation by Social Security, total $3,100,000 as of 2024. Divided by 35, they average $88,571. This means Chuck has filled the 90 percent replacement bend point (up to $14,088) and filled the 32 percent replacement bend point (from $14,088 to $84,936) of average annual earnings. If Chuck continues to work, his wages will be replaced at a 15 percent replacement rate by Social Security. 

If Chuck retires now and earns nothing more, his annual Social Security benefits, expressed in 2024 dollars, will look something like this at full retirement age:

Replacement Rate	Replaced Annual Income	Annual Social Security at Full Retirement Age
90%	$14,088	$12,679
32%	$70,848	$22,671
15%	$3,635	$545
Total	$88,571	$35,896

Note that I rounded each bend point’s calculation. With the cents Chuck gets in each bend point, his total is increased by almost a full dollar. Similar rounding applies to the examples below as well.

At age 67, Chuck’s annual Social Security will be $35,896 (expressed in 2024 dollars).

If Chuck continues to work for one more year at a $130,000 salary, and then retires his annual Social Security benefits at full retirement age, expressed in 2024 dollars, looks something like this:

Replacement Rate	Replaced Annual Income	Annual Social Security at Full Retirement Age
90%	$14,088	$12,679
32%	$70,848	$22,671
15%	$7,349	$1,102
Total	$92,285	$36,453

Interestingly, an additional year of work only increased Chuck’s annual Social Security benefit by $557. Why is that? Remember that every dollar earned is divided by 35 for purposes of computing Social Security benefits. You can see that Chuck’s replaced income increased by $3,714 (from $88,571 to $92,285). By earning $130,000 in 2024, Chuck increased his Social Security average annual income by $3,714, which is $130,000 divided by 35.

Multiplying the increase in replaced income ($3,714) by the replacement rate (15%) gets us the additional $557 in annual Social Security benefits. 

Okay, but what about three more years of earnings. Say Chuck can work for three more years at an average annual salary of $135,000. What result (in 2024 dollars) then? 

Replacement Rate	Replaced Annual Income	Annual Social Security at Full Retirement Age
90%	$14,088	$12,679
32%	$70,848	$22,671
15%	$18,920	$2,838
Total	$103,856	$38,188

Where I come from, $1,735 ($38,188 minus $36,453) in increased annual Social Security benefits at full retirement age is not nothing. But is it worth delaying retirement for three full years if one is otherwise financially independent? To my mind, probably not. 

Spousal Benefits

What if Chuck is married to Mary? How does that impact the analysis?

During Chuck and Mary’s joint lifetimes, it depends on whether Mary collects spousal benefits. If Mary has Social Security earnings of greater than 50 percent of Chuck’s Social Security earnings, she will likely collect benefits under her own earnings record, and not a spousal benefit. Thus, Chuck’s Social Security earnings will be irrelevant to the Social Security benefit Mary collects.

If, however, Mary’s lifetime Social Security earnings are less than 50 percent of Chuck’s, Mary is likely to collect a spousal benefit of roughly half of Chuck’s annual benefit. In this case, Chuck working 3 more years creates $2,603 of additional annual Social Security income ($1,735 for Chuck and $868 as Mary’s spousal benefit). Even $2,603 in additional annual income isn’t likely to justify Chuck working for three more years.

At Chuck’s death, assuming Chuck predeceases Mary, Mary will collect the greater of her own Social Security benefit or Chuck’s Social Security benefit. Thus, Chuck increasing his Social Security earnings could increase Mary’s Social Security benefit as a widow.

I’ve got a plan to save Social Security and Medicare.

Resource

Most people I know cannot tell you their Social Security earnings record off the top of their head. But, this information is accessible by creating an account at ssa.gov. From there, Americans can obtain their Social Security statement which includes their Social Security earnings (though the statement does not adjust those annual earnings for inflation). The 2024 factors to increase annual earnings for inflation can be found by entering “2024” in the search box at the bottom of this SSA.gov website.

Conclusion

There are many factors to consider before retiring early. It is helpful to understand how Social Security benefits are computed so early retirees can understand the potential impact of retiring on their Social Security benefits. 

FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com

Follow me on Twitter at @SeanMoneyandTax

This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.