Every week we here at ChooseFI get hundreds of emails from our community. There have been so many engaging and thought-provoking questions that we created a series dedicated to answering the most frequently asked each week.
This week’s question is about inflation’s impact on the Safe Withdrawal Rate (SWR) or the 4% Rule and comes from Brandon, who writes:
When determining my FI number and seeing the current projection is ie, 7 years to reach $2 million which is my new figure. However, in 7 years I will need roughly $2,140,00 for 2% inflation per year so do I need to incorporate inflation in my future number?
My understanding is once I get to 2.14 million in 7 years the 4% rule of thumb incorporates inflation going forward. When I say includes I mean market avg (est 8%) minus 4% and leftover handles inflation/taxes/fees/etc. Am I thinking through the first part correctly that once I determine my current annual expenses * 25 then I need to factor in inflation too? I don’t know if I had ever heard anyone (FI podcasts, websites) mention the inflation part leading up to reaching your FI number.
The 4% Rule and Inflation is a hot topic considering the current economic environment and it’s important to state right up front that the 4% Rule does factor in “standard” inflation, considering a 7-8% market. So how do we get to 4% SWR from a 7-8% return?
Why Is the Safe Withdrawal Rate 4%?
The team from Trinity University who brought the world “The 4% Rule” studied the market and hundreds of variables over the time period from 1929 to 1995. With findings of about a 7-8% annual market return, and considering economic forecasts of a steady 3% inflation rate, they hedged towards a 7% market return less the 3% inflation.
7% – 3% = the 4% SWR.
So standard inflation is baked right into the calculation and is accounted for.
Now, this is simply a starting point. A rule of thumb – determined by using empirical evidence of the market with a massive sample size over decades.
We constantly talk about the 4% Rule of Thumb because we are trying to make ideas about FI as easy to understand as possible. It won’t be perfect in 100% of future scenarios but as a realistic North Star, it’s a great thing to shoot for.
How Does Changing Inflation Play a Role?
In early 2022, the American consumer is staring down the barrel of a 6+% inflation rate: double the average that was forecasted in the Trinity Study. This is due to inventory shortages, logistical and supply chain issues, a job market in flux, and high demand for standard goods. This combination of supply-side shortages, downward pressure on employment, and demand far exceeding supply – all create an inflationary environment.
It is simply impossible to forecast how long inflation of this magnitude will stick around or if this is structural and will be with us for many years to come.
It is therefore too early to say if we need to adjust our SWR at this point in time.
But clearly, if we upwardly revise the structural inflation rate and the market return doesn’t change, then our previous formula looks very different and therefore our SWR must be reduced.
This means you will need to increase your FI Number.
Risk Tolerant or Risk Averse?
If you want to be more conservative, you can start downwardly revising your SWR now as part of the calculation for your FI Number.
How this would work is if you wanted to say 3% was a more comfortable SWR for you, then instead of multiplying your annual expenses by 25 to get to your FI Number (which would be based on a 4% SWR), you would instead multiply your annual expenses by 33.3 to get your new FI Number.
The same holds true if you wanted to be slightly more aggressive with your FI Number — you could, for instance, increase your SWR from 4% to 5%.
In that case, to get your FI Number, you would multiply your annual expenses by 20.
The Bottom Line
Remember, your FI Number is your ultimate goal, but it isn’t going to be calculated once and set in stone. You need to keep up-to-date on the broader inflation number, plus the outlook for market returns. We feel comfortable based on current information to say somewhere in the range of a 3% – 4% SWR will likely lead to success over the long-term, but you need to adjust accordingly based on your risk tolerance and economic facts as they change.