Published On: Sat, Nov 27th, 2021

Early retirement: Britons can retire early but warned FIRE four percent rule has ‘big risk | Personal Finance | Finance

Financial Independence, Retire Early, or FIRE as it is commonly known, is a goal set by increasing numbers of people keen to depart the workforce before the traditional age of 60 or 65. However, as retirement involves having enough cash to see one through life without a regular salary or wage, it often requires significant forward planning. One way of doing so is following the four percent rule which many view as the key to planning a successful retirement.

“It came about in the early 1990s and was based on a basic model – on a retiree having a lengthy 30 year retirement. But there are a lot of other assumptions.

“In essence, the four percent rule states if you aggregate all your retirement assets, take four percent – that is your income for year one. Then you add inflation to that every year. 

“For example, if all your assets in a pension, savings and ISAs add up to £1million, four percent of that is £40,000. Inflation is two percent, then the next year you take £40,000 plus another two percent, equalling £4,800. Then increase it by inflation each year.”

Many people will make the four percent rule an essential part of their plan for retirement, whether choosing to depart from the workforce early or not.

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However, Mr Norton has warned that while this can be a great starting point, there are risks involved with this perspective.

He continued: “The first big risk with the four percent rule is that it is based on a 30 year time horizon. But what we know from FIRE is that many people will be retiring for upwards of 30, 40 or 50 years. Therefore, they need to look at a lot of the assumptions going in to the four percent rule – and there are risks in this sense.

“Original analysis for the four percent rule was based on historic returns in the US stock market from 1926 onwards.

“From 1926 to 2021, US stock markets grew at over 10 percent each year, they were really strong. But our median expectations in the next 10 years are nearer four percent. This is translatable to what is happening in the UK also.

“So if you are going to align investments and they deliver 10 percent, excellent. But if you’re taking out four percent and they deliver four percent a year – that’s where the problem occurs.

“If you have a relatively low risk arrangement, you’re going to get a substantially lower return over the next 10 years than you would’ve previously received in the last 40 or 50 years.”

However, an equally important point to consider when it comes to the four percent rule is the concept of costs.

Mr Norton warned costs can end up being the turning point for success – not only high costs but costs as a whole.

He said: “Looking at the chances of success over a 30, 40 and 50 year period is key, particularly at different levels of costs.”

Vanguard research found that using the four percent rule, there is a pretty high chance of not running out of money in 30 years – about 85 percent probability of success.

Mr Norton added: “But if you increase that to 40 years, the probability of success falls dramatically to 55 percent chance of not running out of money.

“For 50 years, we think that probability of success falls to just under 40 percent. But all of this is with no costs involved.”

But when savers take costs into account, they could be facing even more of a significant hurdle when it comes to the idea of retiring early.

Vanguard analysis shared with showed that in an arrangement where costs are at one percent per annum over 50 years, the chances of success drop to under 15 percent.

As a result of the potential flaws to the four percent rule, Mr Norton advised Britons to consider their options as well as their plan for retirement.

He concluded: “It is kind of a cautionary tale for investors to control your costs as this is one of the only things people can actually control.

“Take a slightly more pragmatic approach, a more dynamic approach. Don’t tie yourself down to a specific idea about your retirement.

“And FIRE is something which has to really be considered before embarking upon it.” 

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