The so-called 4% rule has only been around for a few decades, but it’s become a rule of thumb for financial advisors and investors looking for guidance on estimated yearly income withdrawals in retirement.
Here’s what to know about the 4% rule in retirement.
— The origins of the 4% retirement withdrawal rule.
— What is the 4% rule?
— Tax ramifications of the 4% rule.
— Know how the 4% rule works.
— The pros of the 4% rule.
— The cons of the 4% rule.
— Alternatives to the 4% rule.
The Origins of the 4% Retirement Withdrawal Rule
In 1994, financial advisor William Bengen set out to answer the question of how much an individual could safely spend each year in retirement without running out of money. His answer: the 4% rule.
“Based on his findings, this was the starting amount that could be withdrawn in retirement for a 50/50 portfolio to last at least 30 years,” says Katherine Tierney, certified financial analyst and senior retirement strategist at Edward Jones.
While not universally adopted by money managers and retirees, the 4% rule has become the closest thing to an annual retirement income withdrawal benchmark for the masses.
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What Is the 4% Rule?
The 4% rule is designed to be an “aiming point” for retirees wondering how much they should live on based on their retirement savings — at least annually.
“The original concept of the 4% rule is that to maintain your ability to draw from your investments in retirement without running out, you draw 4% in the first year of retirement,” says Isabel Barrow, director of financial planning at Edelman Financial Engines. “Conceptually, this means that from a $1 million portfolio, you could draw $40,000 per year with a very low risk of running out over 30-plus years.”
“Originally, the rule also assumed that you could take a little more year after year to account for inflation, and it was based on a 50/50 mix of stocks and bonds,” Barrow adds.
Over the past three decades, the 4% rule has become a popular rule of thumb that’s straightforward to understand. “It answers the question almost every retiree has on their minds,” says Brian Fricke, senior vice president and financial advisor at Wealth Enhancement Group. “How much money can I comfortably withdraw from my investments without significant risk of running out of money during retirement?”
The rule assumes you invested 50% of your money in stocks and 50% in bonds during your working years. “You would adjust your withdrawal rate each year based on the yearly change to inflation,” Fricke says. “The strategy was designed to survive the worst market conditions over 30 years.”
While Bengen’s original research only used two asset classes — Treasury bonds and large-cap U.S. stocks — he recently added a third asset class, small-cap stocks. “In doing so, Bengen has basically increased the safe withdrawal rate from 4% to 4.7%,” Fricke notes.
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Tax Ramifications of the 4% Rule
Another investment strategy is the 60/40 portfolio. Structurally, the 4% withdrawal rule states that a 65-year-old retiree who has a 60/40 portfolio (60% equities, 40% bonds) can also safely withdraw up to 4% from their portfolio each year without worry of depleting their funds or outliving their portfolio.
“This is based on the idea that a 60/40 portfolio can be expected to return 6% to 7% annually on average,” says Carla Adams, founder and financial advisor at Ametrine Wealth, a wealth management company. “Four percent goes to you to support your cost of living, while the remaining 2% to 3% stays in your portfolio to continue to grow to account for inflation.”
Meanwhile, the portfolio principal continues to grow in nominal dollars and maintains its value in real dollars, on average over the long term.
“Keep in mind this is a portfolio withdrawal amount, so the 4% rule allows you to spend up to 4% of your portfolio, plus you can spend any additional income (that does not come from your portfolio) such as Social Security, pension income, hobby income, any rental income you receive or part-time work income, for example,” Adams says.
Retirees should be cautious that some of the portfolio cash you’re withdrawing as part of the 4% will be to pay income taxes, particularly if you are making non-Roth IRA or 401(k) withdrawals.
“For example, if you have a $1 million portfolio, you could theoretically withdraw 4% or $40,000 per, year,” Adams says. “But if some or all of that $40,000 is coming from an IRA, then a portion of that $40,000 will need to go to the IRS, with the amount depending on your federal tax bracket (the same goes for state taxes).” So that $40,000 withdrawal amount may actually be $30,000 of actual spending money.
“That’s why I strongly advise working with a financial advisor to model out how the 4% rule, once applied, will look like in various stages of your retirement,” she adds.
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How the 4% Rule Works
Here’s how the 4% rule works in practice.
Let’s say you have $1 million for retirement.
“In year one, you would withdraw $40,000 for spending and taxes ($1,000,000 x 0.04),” Tierney says. “In year two, you would adjust this amount for inflation. So, if inflation were 3%, you would withdraw $41,200 ($40,000 x 1.03). In year three, you would adjust the $41,200 for inflation and so on through retirement.”
Basically, the 4% rule offers a quick and easy way to assess whether your retirement spending goals are realistic.
“However, it’s based on certain assumptions, and the farther away those assumptions are from your situation, the less valid the rule may be for your unique retirement income needs,” Tierney says.
“For example, using our own capital market assumptions, we believe someone starting withdrawals in their mid- to late-60s can take an initial withdrawal of 3.5% to 4%, increased by 3% annually, assuming a life expectancy of 92 and primary goal of retirement spending,” Tierney states.
There are three caveats to the 4% rule based on those assumptions, Tierney notes. They are:
1. If your retirement time horizon is longer (due to earlier retirement or longer life expectancy), then your starting withdrawal rate likely needs to be reduced. “Conversely, if your retirement time horizon is shorter, you may be able to afford a higher starting withdrawal,” she says.
2. If you want to leave a legacy to your heirs or plan for a higher rate of inflation, then your starting withdrawal rate may need to be reduced.
3. Where you target within the formula’s recommended range may vary depending on your spending flexibility, how much you rely on your portfolio for income and your risk tolerance.
The Pros of the 4% Rule
It’s a stable formula. Anyone with a calculator can quickly and simply determine their withdrawal rate by taking 4% of their portfolio value. “It doesn’t change year after year, aside from an optional inflation increase annually, and that makes it also predictable and easy to maintain without frequent adjustments,” Barrow says.
The formula has aged well. “The 4% rule is a tested theory that is generally accepted as a good rule of thumb when determining income during retirement,” says Matt Mancini, wealth planning team leader at Wilmington Trust. “It can make planning projections easier over the course of a retirement.”
The Cons of the 4% Rule
The math may not add up. The most obvious “con” is the 4% rule was created using historical return results — yet past performance does not guarantee future results.
“Thus, if you become too stuck on a simple percentage rule of thumb, you may be spending too much if future returns are lower than in the past,” Barrow says.
The rule doesn’t take into account how retirees live. Most people have somewhat varying expenses for things like travel, home repairs, taxes, health care and household bills.
“The 4% rule is rigid in that you can’t take more than your annual percentage, meaning you have to be a lot more efficient with your cash on hand to cover your extras,” Barrow notes. “In my experience, people prefer to review their retirement plans every year or two years to reevaluate their expenses and income stream.”
Once again, working with a financial advisor to review long-term income plans can help.
“Partnering with a financial advisor can give you more visibility into how your actual returns, expenses and personal rate of inflation have impacted your current and future income stream,” Barrow adds.
Alternatives to the 4% Rule
As retirees generally live longer today than they did even 25 years ago, some financial experts say the 4% rule may have lived out its usefulness.
“The problem with the 4% rule is it is designed to survive even the worst-case situations, which is only sometimes the case in most circumstances,” Fricke says. “Retirees following the so-called 4% rule tend to underspend in retirement. That may be causing them to make unnecessary lifestyle sacrifices that, in hindsight, wouldn’t have been necessary.”
Additionally, the 4% rule doesn’t consider other income sources such as pensions, Social Security, annuities or part-time work and income. “Consequently, depending on your situation, you may not need a 4% withdrawal rate to generate your desired retirement income,” Fricke notes.
One potentially better approach is a flexible or dynamic withdrawal strategy, sometimes called a guardrail approach to retirement income withdrawals from investments.
“Think of the guardrails you see on the highway,” Fricke says. “They’re installed to prevent your car from veering off the side of the road into the ditch. Regarding retirement income, think of an upper guardrail and a lower guardrail; they keep you from running out of money while not leaving too much behind.”
Using this approach, Fricke believes a retiree’s initial withdrawal rate could be 5.5% if the retiree is willing to make adjustments along the way.
“Here, if your investment values drop below your lower guardrail, you will take a temporary ‘pay cut’ of 10% until your account balances get back above your lower guardrail amount,” Fricke says. “This usually takes a 20% decline in income values.”
Better yet, because markets tend to go up more often than down, you could earn a “pay increase” when your investment values increase above your upper guardrail. Fricke notes, “This usually takes a 20% increase in income value.”
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How Much Should You Spend in Retirement? Use the 4% Rule originally appeared on usnews.com
Update 11/08/23: This story was published at an earlier date and has been updated with new information.
