Beyond the 4% Rule
Warren Buffett's Look-Through Earnings Approach to Retirement Planning
For decades, the 4% rule has served as the gold standard for retirement planning. But it really isn’t built for the FIRE movement. The principle is straightforward: withdraw 4% of your portfolio in your first year of retirement, then adjust that amount annually for inflation. But what if there's a more intuitive way to think about sustainable withdrawal rates? Enter Warren Buffett's concept of "look-through earnings" – a perspective that might forever change how you view your retirement portfolio.
The Limitations of the Traditional 4% Rule
The 4% rule, developed by financial advisor William Bengen in the 1990s, has helped countless retirees. However, it has limitations:
It doesn't account for varying market valuations
It assumes a fixed withdrawal rate regardless of economic conditions
It focuses on portfolio value rather than the underlying business performance
These limitations can lead to either unnecessarily restricting your lifestyle or potentially running out of money. What if we could find a more fundamental approach?
Understanding Look-Through Earnings
Warren Buffett doesn't primarily focus on stock prices. Instead, he evaluates investments based on their "look-through earnings" – the portion of a company's earnings that belongs to him as a shareholder.
As Buffett explains in his shareholder letters; look-through earnings represent our share of the earnings of our investee companies – what they earn, not the dividends they pay.
This concept is powerful because it shifts focus from arbitrary withdrawal percentages to what your investments are actually earning.
How Look-Through Earnings Work for Retirement Planning
Let's break this down with a simple example:
Imagine you have $1,000,000 invested in the S&P 500 index. If the current Price-to-Earnings (P/E) ratio is 20, this means:
For every $20 invested, companies generate $1 in annual earnings
Your $1,000,000 investment represents ownership of $50,000 in annual corporate earnings
This $50,000 represents your "look-through earnings" – the amount your invested businesses are earning on your behalf annually. This figure provides a logical framework for the maximum you might reasonably spend in a year.
Why This Approach Makes Intuitive Sense
Think of your portfolio as a business you own. Would you withdraw more than your business earns over the long term? Probably not, as that would eventually deplete your capital.
The look-through earnings approach connects your spending directly to what your investments are actually producing, rather than relying on an arbitrary percentage rule.
Some advantages of this method:
It's fundamentally grounded: Your withdrawal is based on actual business performance
It's adaptive: As market valuations change, so does your withdrawal amount
It provides psychological comfort: You know you're living within the means of what your investments are actually generating
Practical Implementation
To apply the look-through earnings approach to your retirement planning:
Calculate the total value of your portfolio
Determine the P/E ratio of your holdings (this can be found for indexes or individual stocks)
Divide your portfolio value by the P/E ratio to find your annual look-through earnings
Use this figure as a guideline for sustainable annual withdrawals
For example:
$1,000,000 portfolio in the S&P 500
S&P 500 P/E ratio: 24
Look-through earnings: $1,000,000 ÷ 24 = $41,666.67
This suggests you could sustainably withdraw around $41,666 annually (comparable to a 4.16% withdrawal rate in this example).
Ignoring the Noise
One of the strongest features of this approach is how it naturally adjusts for market conditions, and keeps you focused on what matters:
When your holdings move up or down on a normal market day, you stay focused on the earnings, which probably didn’t move on that day
During market bubbles (high P/E ratios), it would suggest lower withdrawal rates
During market crashes (low P/E ratios), it would allow for higher withdrawal rates
This automatic adjustment helps protect your portfolio during overvalued markets and prevents unnecessary frugality during undervalued markets. While it should keep you from overspending, it will also keep you focused on what matters instead of the price of the most motivated buyers and sellers.
Caveats and Considerations
The look-through earnings approach isn't perfect:
Earnings fluctuate: Corporate earnings can be volatile year-to-year
Quality matters: Not all earnings are created equal (some businesses have more sustainable earnings than others)
Cash flow vs. earnings: Companies retain some earnings for growth, so not all earnings translate to cash available for dividends
Companies lie: You probably want a margin of safety in case this happens to you
To address these concerns, you might consider:
Using a trailing average of earnings (perhaps 3-5 years)
Building a margin of safety by withdrawing less than total look-through earnings (I am personally withdrawing 35% of look-through earnings to leave a margin of safety)
Focusing on companies with stable, high-quality earnings
Conclusion: A More Intuitive Approach to Retirement Spending
The traditional 4% rule has served retirees well, but Warren Buffett's look-through earnings concept offers a more fundamental framework for thinking about sustainable withdrawals.
By focusing on what your investments are actually earning rather than arbitrary percentage rules, you can develop a more intuitive sense of what's sustainable. This approach naturally adjusts for market conditions and connects your spending directly to the underlying performance of your investments.
Next time you're planning your retirement withdrawals, ask yourself: "What are my investments actually earning?" The answer might give you a clearer picture than any percentage rule ever could.
Disclaimer: This article is for informational purposes only and does not constitute financial advice. Always consult with a qualified financial advisor before making significant changes to your retirement strategy.