The 4% Rule is arguably the most famous strategy for making sure your retirement income lasts long. Developed in the 1990s, it offers an evidence-based answer to most retirees’ question: “How much can I spend each year?” This article tackles the basics of how the 4% Rule works and explores some alternative strategies.
Overview Of How The 4% Rule Works
The 4% Rule was introduced by financial advisor William Bengen in 1994. His research was based on historical market data starting from 1926 and it showed that a balanced portfolio could safely sustain a 4% inflation-adjusted withdrawal rate over a 30-year retirement. The rule’s validity was further supported by a 1998 study by professors from Trinity University, which confirmed the high probability of success across various equity-heavy asset allocations.
Applying this strategy is fairly straightforward. You only need the initial portfolio balance to compute the 4% withdrawal rate for the first year, and then the subsequent annual inflation rate for succeeding years.
First, you have to calculate the initial withdrawal based on the investment value of your retirement savings. For example, if you have a total retirement savings (from IRAs, 401(k)s, taxable brokerage accounts) of $2.5 million, the first year’s withdrawal rate is $100,000 (calculated as $2,500,000 x 0.04). This amount represents the income the portfolio is expected to generate, which you may then supplement with other sources such as Social Security or pensions.
Crucially, after the first year, you shift your focus to the annual inflation adjustment. You will not base your calculation on the remaining portfolio balance – it doesn’t matter to the withdrawal rate for the succeeding years.
Instead, only the dollar amount withdrawn ($100,000 in the example above) is adjusted for the inflation rate. So if inflation is at 3.0%, your withdrawal in the second year of retirement will be $103,000 ($100,000 x 1.03). For the third year, you will use $103,000 as the base amount that you will adjust based on current inflation, and so on.
This makes the 4% Rule a fixed-real-dollar withdrawal strategy. Remember that if you’re applying this strategy, you have to adhere to the inflation-adjusted dollar amount, so that you will have a stable income stream. The 4% Rule relies on portfolio growth to outpace your withdrawals in the long run, regardless of the current portfolio balance.
Finally, the rule also gives you a quick way to calculate your ideal savings target. Because 4% is the reciprocal of 25, you simply have to multiply your desired annual retirement income by 25 to find your target nest egg. For example, if you think you need $80,000 per year from your portfolio, you should have at least $2 million in savings before you retire.
Benefits Of The 4% Rule
1. Simplicity
This strategy makes retirement planning calculation fairly easy. For example, if you are still in the accumulation phase, the 25x savings multiplier gives you a concrete target of how much to actually save to have a comfortable retirement.
Once in retirement, the rule simplifies annual budgeting. Instead of constantly recalculating based on market volatility, you only need to apply the inflation rate to the previous year’s withdrawal amount.
2. High Probability Of Success
As mentioned earlier, the 4% figure is based on statistical analysis of historical data. This amount was not chosen arbitrarily. It represents the maximum withdrawal rate that survived every single 30-year period in U.S. market history, starting from 1926.
This back-testing included the Great Depression, World War II economic shifts, and the 1970s stagflation. While it can be argued that a 4% withdrawal rate is conservative, it gives you a better chance of ensuring your retirement income lasts long.
3. Inflation Protection
This is embedded in the strategy and protects your quality of life, assuming your initial withdrawal amount is enough in the first place. Unlike a fixed nominal withdrawal rate, say, always taking out $80,000 each year, the 4% rule ensures that what you withdraw retains its purchasing power throughout your retirement.
This is a vital aspect, because even a modest 3% annual inflation can halve a fixed dollar amount in about 24 years.
Limitations Of The 4% Rule
1. Sequence of Returns Risk
This refers to the risk of experiencing poor investment returns or losses early in retirement, particularly the first 5 to 10 years. What matters here is the order or timing of when the losses occur and not so much the average returns in the long run.
For example, if the market experiences losses right after you retire, you will be forced to sell a larger quantity of investment shares just to cover the initial 4% withdrawal. This leaves you with a smaller principal, which then has less capital to benefit from future market recoveries and compound growth.
Since the 4% Rule is a fixed-dollar withdrawal strategy, you take out the inflation-adjusted amount every year, regardless of market performance. Even if the average annual return becomes favorable over your entire retirement, the early, large withdrawals during a down market put you at risk of running out of funds prematurely.
2. Fixed Retirement Time Horizon
The core assumption of the 4% Rule is a 30-year retirement, meaning its calculations of the withdrawal rate makes your funds last for 30 years. But what if you retire early? What if you live to be a hundred?
For example, if you are can retire at age 50, the 4% Rule will only sustain your retirement income until age 80. For a longer retirement time horizon, you will need to have a more conservative withdrawal rate, perhaps 3% to stretch your savings. You need to consider your planned retirement age and your family’s history of longevity when applying the 4% Rule.
3. May Be Overly Conservative
The 4% Rule is designed to survive the absolute worst-case scenarios in the market. If you do not experience a Great Depression-level crash (which you probably won’t), your portfolio will not only sustain your retirement but it will grow substantially.
That’s all well and good, but this might mean you needlessly underspent during your most active years. You might have passed up travel opportunities, delayed home renovations, or denied yourself luxuries out of fear of running out of money. While it may also be part of your plan to leave your loved ones a large inheritance, you should also maximize the quality of your life during life. For you, as much as for them.
Some Alternatives To The 4% Rule
1. Spending Guardrails
This approach still maintains a primary withdrawal target, say 4% or 5%, but introduces upper and lower limits to manage spending fluctuations and mitigate sequence of returns risk.
If your portfolio performs well, your withdrawal rate may slightly increase (upper guardrail). Conversely, if you experience losses, you will impose a mandatory spending cut (lower guardrail) to preserve your remaining capital for potential recovery.
This strategy may allow you to boost your portfolio’s longevity while allowing you to enjoy higher spending when the market supports it. A potential drawback is that your annual income will be fluctuating, which can be harder to plan and budget for.
2. Bucket Strategy
Organize your retirement savings into time-based compartments or buckets. For Bucket 1, you should hold enough money for the first three years of expenses in cash or cash equivalents to cover immediate expenses and insulate yourself from market volatility.
For Bucket 2, hold medium-term funds such as bonds, good for 3 to 10 years, then assign your long-term aggressive assets such as stocks for Bucket 3.
By having and spending from the cash bucket, you allow the longer term, growth-oriented assets to recover during downturns, addressing sequence of returns risk. You should note, however, that this strategy requires active management and periodic replenishment of Bucket 1 from the earnings of the other buckets.
3. Fixed Percentage Withdrawal
This is the mathematical opposite of the 4% Rule. Instead of having an inflation-adjusted withdrawal amount, you set a fixed withdrawal rate based on the current market value of your portfolio every year.
The key benefit of this approach is that you’re guaranteed to never deplete your portfolio, since the withdrawal rate adjusts downward with the balance. However, this means you will have highly volatile yearly income, because your withdrawal is completely at the mercy of the market.
Final Thoughts
The 4% Rule can be a solid starting point for retirement income planning, thanks to its simplicity and inflation protection. However, its relative rigidity and inherent assumptions mean it is not a one-size-fits-all strategy. You may consider alternatives, such as Spending Guardrails, the Bucket Strategy, or Fixed Percentage Withdrawal, to address its limitations. Better yet, consult a financial advisor to get expert advice tailored to your circumstances. They can help you determine the optimal retirement withdrawal rate that fits with your overall financial strategy.
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