The 4% Rule, Inflation & Building Wealth In Retirement

People seem to get tripped up with concerns about how inflation will impact their retirement.

You hear stuff like: “I’m making so-and-so assumptions about inflation after I retire so I can get my portfolio size and safe withdrawal rate just right.”

Or: “What if inflation doubles once I enter my golden years; won’t it kill my wealth?”

Or even: “Bro, I’ve seen pics, man, pics of dudes with wheelbarrows filled with cash to buy a loaf of bread. It happens, yo. That’s why I’m all about gold. And why I wanna go back to Bretton Woods. Yo.”

All right. First of all, don’t “yo” me, brah. Second, gold is a long-term investment useful only for people who have terrible teeth. And/or rappers. Third, Bretton Woods, the gold standard and anything but fiat currency in the modern era are ridiculous notions that would impoverish us all. And fourth, hyperinflation is beyond unlikely to happen in the United States during our lifetimes. Yo.

Which now brings us back to Earth and the more realistic concerns people have about retirement and inflation.

So let me go ahead and get the high-level reassurance out of the way.

Alert: The conventional 4% Rule and the FL-Approved 3.5% Rule directly account for inflation.

The rules are inflation-pegged. And since they’re formulated on the basis of actual historical market activity in the U.S., they’ve been backtested through all sorts of inflationary environments.

Which means you don’t need to separately worry about inflation, especially if you’re properly allocated and are withdrawing at the FL-Approved rate. It’s all built into the statistics.

We went through the particulars of the 4% Rule and how to make it work for us six-packed and stacked Luchadores some time ago. So we won’t repeat that here. But anyone who has not read those posts (linked above) should do so for a complete treatment of this subject.

In this post, we’ll add to that discussion and more formally account for the inflation concern using some brand-spanking-new research undertaken by our old friend, Wade Pfau.

Getting Pumped

You may recall Sir Pfau from our rather unsightly beatdown of some of his earlier research relating to the 4% Rule. Which is to say I don’t endorse all his work. But he recently did some pretty useful empirical study to formally investigate the impact of inflation on retirement portfolios.

And so we throw Señor Pfau a grateful salute from the ring and wade into the findings.

(Note: Unlike some financial commentators, Dr. Pfau is a real, actual economist who did his grad work at Princeton and seems to have a genuine interest in making his research helpful to people. So, even if we don’t agree with all his findings and conclusions, we respect the spirit of his work here. Beware others without such orientation who peddle dime-store financial advice.)

We already know from Bengen’s research underpinning the 4% Rule that if we withdraw an inflation-pegged 3.5% from our portfolios each year we won’t run out of funds for 50 years plus.

We also know that if we allocate in retirement for sweet long-term wealth accumulation using a 75%/25% stocks/non-stocks mix, our financial outcomes will be much better than those associated with the kamikaze 50/50 stocks/bonds mix typically assumed for 4% Rule studies.

Directionally, the FinanciaLibre adjustments to the 4% Rule mean we’ll not only keep money in the portfolio for 50+ years; they also mean we’re likely to grow the portfolio over our retirement – without making any new deposits into it; all growth is organic/internal/passive/sweet and in excess of our withdrawals. Meaning we’ll be wealthier when we die than we are at initial retirement after paying for a great lifestyle all along the way. Which is mighty nice for us, not to mention our spawn.

And this is precisely where Pfau’s latest research comes in.

He asked two related questions:

1) What’s the maximum retiree withdrawal rate that, after 30 years, would leave a portfolio with at least as much nominal value as it started with? Meaning: If you retire at age 30 with $1 million, what’s the max draw rate that will leave you with at least $1 million in the nut at age 60?

2) What’s the maximum retiree withdrawal rate that, after 30 years, would leave a portfolio with at least as much real value (i.e., inflation-adjusted value) as it started with? Meaning: If you retire at age 30 with $1 million, what’s the max draw rate that will leave you with at least $1 million in equivalent purchasing power at age 60?

To conduct his analysis, Pfau looked at hypothetical retirees all the way back to 1926 and determined, given market performance, inflation, etc., what their maximum withdrawal rates could have been to satisfy those nominal and real wealth maintenance tests.

Now, Pfau assumed the 50/50 stocks/bonds mix and only used a 30-year horizon (as well as all the other traditional assumptions built into these types of analyses). But all that really means for us Luchadores is that his results should give us incredible peace of mind that our 3.5% Rule and 75/25 mix will leave us very well off throughout our long and satisfying retirements.

And all this should go a long way in allaying concerns about inflation risk in retirement.

(Unless, of course, you’re a logy conspiracy theorist convinced U.S. government-published inflation figures are fictionalized statistics meant to exert mind control and can’t be trusted for use in empirical research or planning. Which is something inexplicably believed by some out there and a topic we’ll maybe address another time, entirely for fun, because the whole notion is National Enquirer-stupid.

Headline: “Janet Yellen Births Twin-Headed Alligator Baby, Admits to Decades of Falsified Economic Statistics; Ben Bernanke Implicated in Both Stories. Shocking Photos!”)


Let’s first summarize the more stringent test from Pfau’s analysis: What max draw rates enable us to maintain real wealth after 30 years?

This is the test that directly addresses inflation since it gives us withdrawal rates that, even after the withdrawals are deducted, enable our portfolios to grow at a rate that equals inflation. That is, making withdrawals at these rates, portfolios in Pfau’s analysis did not lose any real value over 30 years. If a retiree started with $1 million in purchasing power, that retiree still would have $1 million in purchasing power in the portfolio after three decades.

Over the 91-year period studied, the average allowable withdrawal rate to maintain real wealth was 4.6%, and the median was 4.32%.

The lowest observed withdrawal rate that maintained real wealth was 2.72%.

The maximum was 8.52%.

Yes, you are reading this correctly. Some portfolios could have utilized withdrawal rates of 8%-plus and still grown in real value over 30 years – with no additional deposits. Just plain old geometric compounding.

Here’s a pie chart summarizing the distribution of max withdrawal rates to maintain real value over 30 years. To construct the chart, I counted the number of times the allowable max withdrawal rates occurred within the following ranges: 5% or more; 4% to 4.99%; 3% to 3.99%; and 2.99% or less. I then converted those counts to percentages. So each piece of pie represents the percentage of portfolios observed that had allowable max withdrawal rates within those categories (e.g., 31% of portfolios had max real-wealth-maintaining withdrawal rates of 5% or more).

Max Withdrawal Rate for Real Wealth Maintenance
Max Withdrawal Rate for Real Wealth Maintenance

For the less-visual among us, here’s a Luchadorian takeaway from the chart: 97% of observed portfolios could withdraw at rates of 3% or greater and still grow in real value over 30 years.


Flat Tire

The more pedestrian test from Pfau’s analysis asked about nominal wealth maintenance over 30 years. As your intuition is telling you, the withdrawal rates allowable to keep nominal value intact are much higher than for real wealth maintenance.

Why do we care about this?

Well, if your goal is to, say, pass down to your heirs $X, regardless of what the buying power of $X is after you get flattened by a bus or whatever, this kind of analysis matters for you.

Over the 91-year period studied, no withdrawal rate lower than 3.77% was necessary to maintain nominal wealth over 30 years. And only four of 61 portfolios required withdrawal rates below 4%.

The highest allowable rate was 9.25%.

As in: Just adopt the basic themes of the FL-Approved 3.5% Rule and the optimal allocation mix and fuhgeddaboudit.

The following table summarizes Pfau’s findings:

Pfau Analysis Summary
Pfau Analysis Summary

Sucking Sound

“Why tell peeps to use only a 3.5% rate when they’re probably good with a much higher one, bro?” you inquire.

It’s about surety and peace of mind.

What’s the point of retiring early if you spend every day sweating the pennies?

Isn’t the whole point of early retirement an escape from the must-earn-money-save-money worker’s hell? It’s not a good deal if we escape work hell only to immediately enter an afraid-to-spend retirement hell.

And the fact of the matter is it’s impossible to know ahead of time whether your retirement portfolio/horizon is one in which a 9.5% withdrawal rate will work, or one where just 4% will work. You only know afterwards, and maybe kind of get an idea along the way.

But without a doubt we can feel good about knowing this: Based on historical statistics, reasoned economic expectations and careful study, the success of a 3.5% withdrawal rate from a properly allocated portfolio is just about as certain as things in life get. And inflation can’t do a thing to change it.

Luchadores, are you still fretting inflation? Or have these statistics given you one less thing to worry about?


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