The 4% Rule for Retirement

The 4% Rule

The 4% rule for retirement is a rule of thumb developed to determine what a safe withdrawal amount is for a retiree on an annual basis. Safe is roughly defined as not depleting the underlying assets for 30 or more years. This is the amount that theoretically balances both ensuring you don’t die destitute but also making sure you can live with the highest income possible given an highly unpredictable market.

At the end of the day, your retirement savings are supposed to provide both safety and comfort. If you and your spouse die and have left a significant amount of wealth on the table, then perhaps the withdrawal rate should have been higher. Alternatively, living the lifestyle of the rich and famous early on in retirement due to a withdrawal rate that is too high may spell disaster. Moderating between the two extremes is what makes the 4% rule so powerful.

As an example: If you retired at the age of 67 with $1,000,000 in retirement you could safely withdraw (according to the 4% rule) $40,000 per year. Add this amount to your Social Security check along with any other annuities or pensions and you will have the amount you can budget for that year.

But what if something calamitous happens?  If in the following year a 2008 style crash occurs (a year where the S&P dropped 38%) you would be able to withdraw:

($1,000,000 – $40,000) x (1-.38) X 4% = $23,808.00

As you can see from the example above, the rule can produce safe withdrawal amounts that fluctuate depending on market movements. If the market has a fantastic year, you may find that you can safely withdraw even more in subsequent years.

Ideally, withdrawing a little more each year would be preferably. Time has shown that generally inflation will eat away at your spending power over time. If inflation is 2% for your first year, then you would need $40,800 the following year to have approximately the same spending power. If invested in stocks and bonds, the risk premium may be able to help offset inflation over a long period. In other words, the longer-term rate of return will likely exceed the rate of inflation.

How was the 4% Rule Created

The 4% figure is data driven. In fact, William P. Bengen, was the first person who derived the amount. In an article he wrote for the Journal of Financial Planning in 1994, he outlines an analysis of the stock market from 1926 to 1976 where if a retiree withdrew no more than 4% of their principal per year then their nest egg would survive at least 33 years.

Thus, if a person were to retire at a full retirement age of 67 and withdrew only 4% then they could possibly live off their savings until at least an age of 100. That’s a powerful rule. The simplicity of it makes it accessible to just about everyone.

The 4% Rule Portfolio Composition

Up until now, I have been waving my hand talking about withdrawing 4% from your retirement ‘investments.’ But what exactly does that mean? Does that mean bonds, stocks, or something else?

For the 4% Rule, Bengen conducted his analysis on a portfolio composed of the following:

30% in an S&P Fund

20% in U.S. Based Small-Cap Stocks

50% in Intermediate U.S. Treasury Bonds

Again, this type of portfolio construction is only mentioned because it was what the author used to develop his rule of thumb. Personally, I could not ever imagine putting half of my hard-earned money into Treasuries but that is what Financial Advisors are paid to advise. Let me say this again: you should consult a Financial Advisor or Planner when determining something as important as your portfolio construction.

Does the 4% Rule Still Work?

Trying to determine if the 4% still works is a complicated and contentious topic… although, in the spirit of how it was first derived, not unanswerable. Keeping in mind that the original author was looking to get someone approximately 30 years of funds to live off, the answer is yes, it is still fairly usable.

In fact, the 4% ‘Rule” has changed a couple of times if you follow the original author. This makes sense. The Stock and Bond markets, which compose the portfolio used to make the rule, change periodically. Mom and Pop’s investment outlook from 40 years ago is probably no longer the most accurate way to view the next 40 years’ worth of risk and return.

In a book titled, ‘Conserving Client Portfolios During Retirement,‘ published in 2006, Bengen updated his guidance to 4.5%.

In an interview in October of 2020 found here, Bengen again updated his guidance to suggest that perhaps 5% is the new maximum withdrawal rate.

Keep in mind that the perfect number does not exist. Whether its 4%, 4.5% or 5%, nothing can beat keeping an eye on your investments and being prepared to update both your withdrawal rate and lifestyle depending on market conditions. The percentage is a planning tool, but the life skill you will really need to apply for a comfortable and safe retirement is flexibility.

What does Dave Ramsey Say?

This is a name I usually try to bring up in any of my articles. Dave Ramsey has been very successful at getting thousands of people to move towards brighter financial futures, however sometimes the numbers that back it up can be misleading. Case in point… Dave Ramsey has suggested that an 8% withdrawal rate is safe.

Understanding why he may recommend 8%, instead of a more conservative 4% is a good starting point on how to approach this higher figure.

First, Dave often recommends a portfolio construction that bends towards high quality growth stocks. These types of stocks are usually heavily weighted in the Technology sector. In the last couple decades, large cap growth stocks have certainly outperformed the S&P (and of course, Treasuries). But, this fact should not overshadow the .com boom and bust of the late 1990’s that saw such growth stocks tumble 90% as tracked by the NASDAQ. Higher returns do also generally mean higher risk after all. So for more risk, higher returns are rewarded in this case.

Second, Dave mentions almost routinely that an individual can earn approximately 12% per year in the Stock market. But is this true?

The Combined Annual Growth Rate (CAGR) of the S&P 500 not taking into account inflation, a more effective way of measuring performance over annualized returns, from 2000 to 2020 was only 8.19%. An 8% withdrawal rate could have been absolutely devastating to say the least when combining in the effect of inflation.

CAGR Calculator: Excellent CAGR Resource to Do Your Own Analysis

However, from 1990 to 2020 it was 10.24% More in line with Dave Ramsey’s expected return. Much in the same way Bengen had to update the 4% Rule over the years… perhaps Dave Ramsey just needs to update his rule… perhaps his should be the 7% Rule.

Either way, both rules of thumb exist. One is based on data. The other is based on personality with a little data on the side. Both are probably wrong but good to consider when trying to determine the best way forward.

Fluctuating Budget Concerns

Relying on a percentage of your principle each year to maximize the amount you can spend while ensuring that you will not fully deplete your nest egg sounds great… but the 4% rule does have a major drawback: the amount you will be withdrawing will fluctuate from year to year.

If you combine the changing nature of the withdrawals with the changing impact of inflation, you’re your buying power each year could be wildly different. So, is using the 4% rule something that you can use?

The answer depends, but the above illustration highlights that the 4% rule is the Maximum Amount that you can theoretically withdrawal. If you are looking for more consistent amounts to budget off of it may make sense to start with a lower percentage, the first year and then only increase the amount you withdraw by the rate of inflation.

But this brings in more complexity. Being able to choose the amount you withdraw can be a complex task if too many parameters are brought in. Perhaps choosing a lower amount each year will stabilize your budget but also may be shortchanging the amount you can spend. Perhaps the best that can be recommended is to live in the moment and spend when you can and pull back when you can’t. Knowing your nest egg is not likely to disappear with only 4% being withdrawn is probably worth the fluctuations.

What About an Emergency?

With such a rigid maximum of 4%, you may be asking yourself what would happen if you had a sudden expense (or desire) that exceeds your budget. This is where an emergency fund (and, insurance) comes in. If, during your working years, a crisis arose that required a significant sum of money you would either utilize your emergency fund or cut something else to make ends meet. Being in retirement is no different.

You should aim to have an emergency fund in retirement just as if you were working. If you deplete part of the fund, then restock it from your budget that does not exceed the 4% withdrawal over time.

Understanding what may be possible when it comes to emergencies will help you to avoid any type of situation where you may have to draw down your nest egg. Between your emergency fund and the proper use of insurance you should be able to mitigate most things that could derail you along the way. 

What if the Market is Way Up? Or, Down?

Watching your retirement accounts do well in the short term can lead to optimism about what the future may hold. This is great unless it leads you to making rash decisions. Watching the stock market bustle with a 30% gain for a single year, however, is just part of the story.

There will be some years that will make you quiver at night… every night… as financial losses may seem like you may have to head back to work until the day you die.

The Stock and Bond markets often see large increases… and substantial decreases. Changing your philosophy due to a single year would be unwise. The only thing you must do is withdraw 4% or less and you will be fine. Your budget may be smaller… perhaps too small for comfort. But that’s life.

If you find that the current year’s budget is a bit on the short side, then you can always consider getting a part time job. Maybe even just for a few months. This would be much preferable to withdrawing your account down while the market is also down.

If you find your budget is a little frothy then consider plussing up your emergency savings or conducting a major home repair that may be needs to be done sooner rather than later. Taking advantage of good fortune can help you when times get tough later down the road.

Final Thoughts

The 4% Rule is an excellent tool for retirement planning. Retiring is way too complex of a topic for anything so simple to answer the mail for everyone, however, it can give you a pretty good ballpark on not only what you can spend in retirement, but also what you may need to save.

4% of a large sum of money probably isn’t that much… probably nowhere near what most people were expecting, but it is an amount that will likely keep your accounts solvent until your final days. Keep in mind, the 4% rule was designed with a 30-year retirement in mind, so all you FIRE folks who retired at 32 may need to adjust your expectations.

Another Word of Caution: rules of thumbs, such as the 4% rule, that were created using simulations of past data can lead to misleading conclusions. Always staying abreast of your risk appetite and how markets have changed can help you steer the ship but make sure you keep your hands off the rudder based on short term market conditions. The thoughts and opinions I have written about in this article are just that: my thoughts and opinions. Financial advice should be left to the experts that you have paid that have a fiduciary obligation to keep your best interests at heart.