Here’s What You Should Know About the 4% Rule

During retirement, you’ll have several goals. Perhaps you want to spend more time with family and friends, learn a new skill, or check off a series of destinations from your travel bucket list. While these goals are admirable, an even bigger objective is ensuring your retirement doesn’t outlive your savings.

There are various methods to accomplish this. One of the most cited strategies is the “4% Rule” established by Bill Bengen in 1994 and published in the Journal of Financial Planning that same year. While his data was based on stock and bond returns over a 50-year period from 1926 to 1976, many financial advisors still rely on this rule today as general guidance.

4% Rule overview

The rule states that you should withdraw no more than 4% of your assets during the first year of retirement. Then, in subsequent years, you can adjust your withdrawals for inflation on an annual basis: either by taking a 2% increase every year (the Federal Reserve’s target inflation rate) or adjusting withdrawals based on actual inflation rates.

In theory, adhering to this rule allows your investments to sufficiently grow and thus prevent you from depleting your funds too quickly over a 30-year retirement period.

Note that the 4% proportion is based on investments only. Therefore, if you receive other sources of income—such as Social Security or a pension check—those are excluded from the withdrawal calculation. In addition, the rule assumes you’ll maintain a balanced asset allocation reflecting 50% invested in stocks and 50% in bonds.

4% Rule advantages

The 4% Rule offers two large advantages: simplicity and predictability.

It’s quite simple to follow. Just calculate 4% of your account balance to establish a base and then add inflation for each withdrawal in subsequent years.

Regarding predictability, the rule makes budgeting easier: as you’ll know how much you can spend every year, adjusted for inflation.

4% Rule disadvantages

The 4% Rule also has several drawbacks.

For starters, it’s very rigid; if you violate the rule in one year to make a large purchase—which is likely, as your retirement expenses will differ from year to year—severe consequences can crop up in later years as you’ve reduced the principal and thereby adversely impacted potential compound interest earned.

While the likelihood of prematurely running out of money while utilizing this rule is slim (according to various studies, an approximate 2-3% probability), it is still always a possibility. This is especially true since the rule is based on historical market returns; while we can’t predict the future, financial markets have experienced more volatility since the rule was initially established.

Another drawback to the rule is that if you’re retired and there’s a protracted market downturn, it can easily erode the value of your investments much more quickly than you had anticipated. Consequently, withdrawing 4% may be too high a number for some—notably those with greater exposure to stocks.

The rule also is based on a 30-year “time horizon” (meaning the period of time you expect to hold your investment until you need the money back), which is perhaps not needed or likely depending on your life expectancy and retirement age. For example, the Social Security Administration estimates the average life expectancy for those celebrating a 65th birthday today is less than 30 years.

Is the 4% Rule outdated?

The answer to this is yes. In addition to the drawbacks we outlined earlier, the rule was developed when bond interest rates were much higher than they are now. It was also designed around a single retirement account—such as an IRA or 401(k)—rather than the diversified mix of accounts and assets most people own today. Bengen himself noted his model isn’t perfect. In fact, he updated his recommendation to 4.5% in 2017 and has since increased the safe withdrawal rate to 5%.

In some of his later work, Bengen even explored the impact of decreasing equity exposure over time rather than maintaining the original 50/50 allocation. This led to the “Rule of 128,” which states that a client’s optimal exposure should be 128 minus their age.

To illustrate, let’s assume you are 70 years of age. Per this rule, you should have 58% in equities. Your research, however, may find that more conservative financial advisors and investors recommend using a rule of 100 or 115 instead: further reducing your equity exposure as you age.

How to determine a safe withdrawal rate

While you can use the 4% Rule as a basic guideline, you should base your specific withdrawal rate on your unique circumstances and goals. In doing so, you’ll need to consider several factors.

For example, let’s take your time horizon; while you can’t guess your exact number of retirement years in advance, you can use various life expectancy tools to achieve a better idea of how long you’ll need to plan for.

Next up is your risk tolerance: meaning how much of an appetite you have to stomach volatility in your investments, driving how they are allocated. If you’re too conservative, you may not make enough money to last throughout retirement. On the flip side, too much aggression can leave you overexposed.

You’ll also need to consider your spending flexibility, which is your ability to spend less in down markets. The more flexibility you have, the more likely your funds will last.

Tax codes and investment fees are additional considerations when developing your own spending rate.

As you can see, calculating a safe withdrawal rate is often a complicated process: which is precisely why we recommend working with a financial planner, as he or she can help ensure you’ll have enough money to last throughout retirement.

When to use the 4% Rule

One way in which the rule is useful is its ability to help you calculate a rough estimate of how much money you’ll need for retirement. For example, let’s say you determine that an annual budget of $50,000 (a number mirroring average retiree household spending) will allow you to live comfortably throughout your golden years. Let’s further assume you’ll receive $20,000 a year from Social Security, which means you’ll only need to withdraw $30,000 from your retirement savings each year. As a next step, you’d divide $30,000 by 4% and get $750,000: the total amount of money you’ll need in your retirement savings to last 30 years.

You may also come across the 25x rule, which is essentially the same concept as the 4% Rule but works by estimating the annual retirement income you need from your investments and multiplying that number by 25. The result—same as the 4% Rule—is how much money you’d need to save to fund 30 years of retirement.

In sum: the 4% rule and retirement

Despite recent updates to the 4% Rule, it generally remains a safe withdrawal rate as numerous researchers have replicated Bill Bengen’s results in the decades since its inception—and, in many cases, substantiated them. However, most financial experts agree you should only rely on this as a general guideline rather than a textbook rule.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.