What Is the 4% Rule?
The 4% rule for retirement budgeting suggests that a retiree withdraw 4% of the balance in their retirement account(s) in the first year after retiring, and then withdraw the same dollar amount, adjusted for inflation, every year thereafter.
The 4% rule is intended to supply a steady stream of income while maintaining an adequate account balance for future years. Assuming a reasonable rate of return on investment, the withdrawals will consist primarily of interest and dividends.
Experts disagree on whether the 4% rule is the best option. Many, including the creator of the rule, say that 5% is a better rule for all but the worst-case scenario. Others caution that 3% is safer.
Key Takeaways
- The 4% rule says people should withdraw 4% of their retirement funds in the first year after retiring and take that dollar amount, adjusted for inflation, every year after.
- The rule seeks to establish a steady and safe income stream that will meet a retiree’s current and future financial needs.
- The rule was created using historical data on stock and bond returns over the 50 years from 1926 to 1976.
- Some experts suggest 3% is a safer withdrawal rate with current interest rates. Others think 5% could be best.
- Life expectancy plays an important role in determining a sustainable rate.
Understanding
The 4% rule is a guideline used by some financial planners and retirees to estimate a comfortable but safe income for retirement.
An individual’s life expectancy plays an important role in determining whether the rate will be sustainable. Retirees who live longer need their portfolios to last longer, and their medical costs and other expenses can increase with age.
History of this
The concept of the 4% rule is attributed to Bill Bengen, a financial adviser in Southern California who created it in the mid-1990s. Some people say that the rule has been over-simplified, because he actually said that the 4% rule was based on a “worst-case” scenario and that 5% would be a more realistic number.
The rule was created using historical data on stock and bond returns over the 50-year period from 1926 to 1976, focusing heavily on the severe market downturns of the 1930s and early 1970s.
Bengen concluded that, even during untenable markets, no historical case existed in which a 4% annual withdrawal rate exhausted a retirement portfolio in fewer than 33 years.2
Accounting for Inflation
While some retirees who adhere to the 4% rule keep their withdrawal rate constant, the rule allows retirees to increase the rate to keep pace with inflation. Possible ways to adjust for inflation include setting a flat annual increase of 2% per year, which is the Federal Reserve’s target inflation rate, or adjusting withdrawals based on actual inflation rates. The former method provides steady and predictable increases, while the latter method more effectively matches income to cost-of-living changes.
Advantages and Disadvantages
While following the 4% rule can make it more likely that your retirement savings will last the remainder of your life, it doesn’t guarantee it. The rule is based on the past performance of the markets, so it doesn’t necessarily predict the future. What was considered a safe investment strategy in the past may not be a safe investment strategy in the future if market conditions change.
There are several scenarios in which the 4% rule might not work for a retiree. A severe or protracted market downturn can erode the value of a high-risk investment vehicle much faster than it can a typical retirement portfolio.
Furthermore, the 4% rule does not work unless a retiree remains loyal to it year in and year out. Violating the rule one year to splurge on a major purchase can have severe consequences down the road, as this reduces the principal, which directly impacts the compound interest that you will depend on for sustainability.
However, there are obvious benefits to the 4% rule. It is simple to follow and provides for a predictable, steady income. And if it is successful, the 4% rule will protect you from running short of funds in retirement.
Pros
- It’s simple to follow
- Provides predictable, steady income
- Protects you from running out of money in retirement
Cons
- Requires strict adherence (doesn’t respond to lifestyle changes)
- Is based on a ‘worst-case’ scenario of portfolio performance
- 5%, not 4%, may be a more realistic number
The Economic Crises
According to Michael Kitces, a financial planner, the 4% rule was developed to take the worst economic situations into account, such as 1929, and has held up well for those who retired during the two most recent financial crises. As Kitces points out:
The 2000 retiree is merely “in line” with the 1929 retiree, and doing better than the rest. And the 2008 retiree—even having started with the global financial crisis out of the gate—is already doing far better than any of these historical scenarios! In other words, while the tech crash and especially the global financial crisis were scary, they still haven’t been the kind of scenarios that spell outright doom for the 4% Rule.
This is, of course, not a reason to go beyond it. Safety is a key element for retirees. So even if following the 4% rule may leave those who retire in calmer economic times “with a huge amount of money left over,” Kitces notes, “in general, a 4% withdrawal rate is really quite modest relative to the long-term historical average return of almost 8% on a balanced (60/40) portfolio!”
Read More:
- Intellectual Property and What Are Some Types
- Collateralized Loan Obligation (CLO) Structure, Benefits, and Risks
- Business-to-Business (B2B): What It Is and How It’s Used
