What is the 4% rule for retirement withdrawals?

You’ll undoubtedly have several goals in retirement. Perhaps this includes spending more time with family and friends, learning a new skill, or checking off a series of destinations on your travel bucket list. While these aims are admirable, an even bigger objective is ensuring you don’t withdraw more money than you've saved over the years.  

You can lean on various methods to accomplish this including one of the most cited strategies—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 the rule today as general guidance.

What is the 4% rule?

This straightforward strategy states you should withdraw no more than 4% of your assets during the first year of retirement and then adjust withdrawals for inflation on an annual basis thereafter: either by taking a 2% increase every year (the Federal Reserve’s target inflation rate) or fine-tuning withdrawals based on actual inflation rates. Note the 4% proportion is based on investments only, so any other sources of income (e.g., Social Security or a pension check) are excluded from the withdrawal calculation.

In theory, adhering to this rule gives your investments sufficient time to grow and thus prevents you from depleting your funds too quickly over a 30-year retirement period. 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. First, the 4% rule is quite easy to follow, requiring you calculate 4% of your account balance to establish a base in year one and then adjust for inflation in each of 29 subsequent years. Second, its inherent predictability makes budgeting a lot easier as you’ll know how much you can spend every year (adjusted for inflation).

4% rule disadvantages

Even so, the 4% rule does have several drawbacks that make it more of a rule of thumb rather than a hard-and-fast rule for retirement withdrawals. For starters, it's very rigid; in reality, your retirement expenses won’t be the same every year and will likely vary thanks to unexpected home repairs, medical expenses, travel, and other pursuits. If you violate the rule, meanwhile, severe consequences can crop up years later as you’ve reduced the principal and thereby adversely impacted potential compound interest earned.

Furthermore, while the likelihood of prematurely running out of money while utilizing this rule is slim (according to various studies, an approximate 2-3% chance), it is still always a possibility—especially since the rule is based on historical market returns. While it's impossible to predict the future, financial markets have indeed experienced more volatility since the rule was initially established.

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

Finally, the rule is based on a 30-year “time horizon” (the period of time you expect to hold your investment until you require the money), which is perhaps not needed nor likely depending on your life expectancy and retirement age. Likewise, the Social Security Administration estimates that someone celebrating a 65th birthday today likely has less than 30 years left to live (on average).

Is the 4% rule outdated?

In short, yes. Beyond the drawbacks just outlined, the 4% rule was established 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 and in fact updated his recommendation to 4.5% in 2017 before increasing the safe withdrawal rate to 5% in 2020.

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: leading to the “Rule of 128,” which states a client’s optimal stock exposure is 128 minus his/her age. For example and per this rule, someone 70 years of age should have an investment portfolio consisting of no more than 58% in equities.

Your own personal 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.

When to use the 4% rule

Rather than rely on the 4% rule as a withdrawal strategy, it's perhaps a little more useful in its ability to help 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 $60,000 (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, meaning you’ll only need to withdraw $40,000 from your retirement savings each year. As a next step, you’d divide $40,000 by 4% and get $1,000,000: the total amount of money you’ll need in retirement savings to last 30 years.

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

How much can you spend during retirement?

While you can use the 4% rule as a basic guideline, you should base your specific withdrawal rate on your own unique circumstances and goals while considering several factors.

Take your time horizon, for example; while it's impossible to 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.

Another factor is your confidence in that your money will last. The higher your preferred confidence level, the less spending flexibility you'll likely have in retirement. With more flexibility, however (e.g., to slash spending during a down market), the greater the chance your funds will endure.

Next up is your risk tolerance: how much of an appetite you have to stomach volatility in investments, determining how to allocate them. While you may not make enough money to last throughout retirement if you're too conservative, too much aggression can leave you overexposed to market volatility.

Tax rates and investment fees, meanwhile, 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 advisor who can help ensure you’ll have enough money to last throughout retirement.

In sum: the 4% rule and retirement

Despite recent updates to the rule, 4% remains a generally 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.

Want to know if you’re on track for retirement and/or how much you can spend during your golden years? Schedule a FREE discovery call with one of our CFP® professionals to learn more.

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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.