Origins of the 4% Rule

Unless stated otherwise, quotes and paraphrases have retained citations and quotes. Bengen’s study looked at market return and inflation data over time periods ranging from 12 years to 53 years, and used them to determine what constitutes a safe withdrawal rate. He examined many 30-year retirement periods, with the movement of the market in both a bear and in a bull market, and his results showed that a retiree could typically take 4 per cent of their initial retirement account balance in the first year of retirement (by subtracting it from the withdrawal account) and then, for every subsequent year, take that same initial percentage of the current balance, adjusted for inflation (multiplying it by the CPI). With this approach, Bengen concluded, retirees had a very high probability that they would not run out of money in any 30-year retirement period.

This—therefore—was the 4 per cent rule, the formula that would gracefully ease retirees over the narrows of their golden years.

How the 4% Rule Works

The mathematical foundation of the 4 per cent rule is pretty simple. In the year of your retirement, you find 4 per cent of your total amount of retirement savings, and that’s the amount you withdraw in your first year of retirement. If you have $1,000,000 saved up, you will use $40,000 (4 per cent of $1,000,000) in the first year of your retirement.

Over the following years, they would index that $40,000 withdrawal to inflation, adding as a percentage onto it each successive year. For example, if inflation is 2 per cent in the second year, they will add 2 per cent to their withdrawals, for a second-year withdrawal of $40,800.

Key Assumptions

For the 4% rule to work as intended, several key assumptions must hold true:

A 30-Year Retirement Horizon: The 4 per cent rule is based on having a 30-year retirement period, which is designed for someone retiring at 65, with the assumption of living to 95. For someone expecting to retire shorter or longer, the rule might need some adjustment.

A Well-Balanced Investment Portfolio: Bengen’s original research was based on the premise that retirees should maintain an equity/fixed income split of 50/60 stocks to 40/50 bonds, which offers the right mix of growth and income needed to keep pace with inflation and withdrawals.

Historical Market Performance: The rule applies to historical U.S. stock and bond market returns in the 20th century – a period of growth in the US economy. Future returns may not be similar.

Annual Inflation Adjustments: The amount that an individual may withdraw each year is adjusted for inflation, so the retiree’s purchasing power is maintained over time.

Benefits of the 4% Rule

The 4% rule offers several advantages, making it popular among financial planners and retirees:

Simplicity: The 4% rule has always held an intuitive appeal, and this simplicity is one of its strongest selling points. This rate allows many retirees – rightly concerned by financial-market complexity, as well as overpriced and overly aggressive ‘analysis’ – to check out of the effort and anxiety of counter-cyclical portfolio management, exchange-traded funds and hidden fees, and instead feel they know exactly how quickly to withdraw – thereby reducing the risk of running out of money in their golden years (monkey years) down the line. Just set the 4%, and – starting with inflation-adjusted money – to heaven one adds, dollars four. Add a couple of per cent annually for inflation, and you’re all set.

The other major attraction of the 4 per cent rule, as Bengen first demonstrated with his research, was this: the mathematics show that with this distribution of your assets you have a very high chance of not outliving your money over 30 years. If longevity risk is your principal financial worry, then the 4 per cent rule gives you a feeling of security.

Inflation protection: This ensures that the percentage of your plan’s assets that you withdraw each year will keep the same real purchasing power for your lifetime. Longevity protection: This guarantees a lifetime of income, typically for life plus a fixed number of years, such as a 10- or 20-year period; alternatively, protecting against negative market returns in retirement. Vanguard then converts each nominated amount into an annuity contract to satisfy IRA requirements. DIY retirees who invest in Vanguard mutual funds and hold these ETFs through Vanguard’s brokerage service, Vanguard Brokerage Services, have access to these guaranteed lifetime income options.

Sensible balanced approach: The 4 per cent rule is dependent on a well-balanced portfolio, which reduces risk but still provides a level of growth sufficient to enable it to keep pace with inflation. This balanced approach works well for retirees who wish to maintain moderate exposure to equities without exposing themselves completely to stock market volatility.

Limitations and Criticisms of the 4% Rule

The 4 per cent rule is, at best, an approximation and, at worst, a gross oversimplification – a topic on which much ink has been spilt. A lot of the critiques are based on changes in the economy, the vagaries of the market, and variations between individuals. Here are some of the main ones:

1. Changing Market Conditions

Bengen’s research had leveraged the relationship between historical market data in the 20th century – a period of robust US economic growth – and household withdrawal amounts. What would happen to the 4 per cent rule in a world of fundamentally different financial conditions? Already in the early 2000s, output growth in the US had moderated, and rock-bottom interest rates since the global financial crisis had pushed bond yields down to all-time lows. Thus lower returns on the fixed-income side of a portfolio might start to undo assumptions inherent in the 4 per cent rule. And the equity market’s volatility and geopolitical turmoil could take a further toll on returns.

2. Sequence of Returns Risk

Sequence of returns risk is the greatest retirement risk we have. In other words, if you have poor returns in the first year of retirement and make a withdrawal at that time, it will devastate your portfolio’s ability to handle withdrawals when, in the long run, they’re supposed to be reduced. Say the market is down 20 per cent over your first year of retirement. You take out 4 per cent, but your portfolio is now down 24 per cent that first year. Let’s say that the exact same thing – 20 per cent negative after four years – happens 100 years from now, and because of the magic of compounding you’re up 10 per cent in equity and have an equal withdrawal of 4 per cent. People won’t complain then, but that exact sequence in the first year is devastating.The 4 per cent rule doesn’t take into account sequence of returns risk; it assumes that people have a consistent, steady withdrawal, regardless of what happens in the market.

3. Variability in Life Expectancy

The 4 per-cent rule figures on a 30-year retirement horizon, while the actual duration of one’s golden years can span decades longer or shorter than that Magic Wand doesn’t account for shorter life expectancies (you could safely and happily withdraw more than the 4 per cent) or longer life expectancies (you could run out of money sooner, potentially necessitating much more conservative withdrawal rates than 4 per cent).

4. Inflation Assumptions

Though the 4% rule accounts for inflation, this number assumes certain inflation rates in certain economic climates, and those may or may not pan out. During times of high inflation, like the 1970s, retirees might find that their withdrawals fall short of covering rising costs of living. On the other hand, during times of low inflation or deflation, retirees might wind up withdrawing too much.

5. Health Care and Long-Term Care Costs

Perhaps the biggest retirement hazard is charges for healthcare and long-term care, both of which are hard to predict and potentially very expensive. The 4 per cent rule doesn’t address these costs, which differ so widely depending on the individual’s health and the extent of insurance.

6. Tax Implications

Another important aspect missing from the 4% rule is the effects of taxes on retirement income. The amount of taxes on retirees drawing on their savings is highly dependent on what specific type of accounts they are taking withdrawals from (e.g. are their withdrawals from tax-deferred accounts or from tax-free accounts). Not accounting for taxes could be a significant issue for those with early access to their savings accounts, since, again, not having taxes reduce the 4 per cent rule to 4 per cent of your savings net of taxes.

Practical Considerations for Applying the 4% Rule

Though the 4 per cent rule is a useful guide, retirees must take stock of a few pragmatic considerations to determine if it is suitable for their circumstances and adjust the basic strategy as needed: 1. Sequence risk investor anxiety about the 4 per cent rule would all be for naught if markets always rose uniformly. But this isn’t how the world works: My retirement can’t be spread evenly through good times and bad; it has to play out in real time. The good news is that there’s an easy way to offset the risk that otherwise low probability events have a silver lining. 2. Market rates retirees are fortunate to have choices. But if they accumulate too many bonus qualifying years, it might jeopardise their retirement portfolio as a result.

1. Flexibility in Withdrawals

Instead of sticking to the 4% rule, a retiree might want to follow a variable withdrawal rule that responds to both economic market conditions and personal circumstances – perhaps spending less during a market slump and more in a particularly strong year of stock returns.

2. Asset Allocation Adjustments

Older retirees might wish to move some of their portfolio out of equities and into bonds or other fixed-income securities, reflecting a more conservative investment strategy. This might improve the chances of their portfolio lasting until the end of their life, but it will reduce growth and, hence, the sustainability of the withdrawal rate.

3. Tax Efficiency

It is critical that those in retirement continue striving for tax-smart withdrawals — making the most of tax-deferred assets, such as traditional IRAs or 401(k)s, before the tax-free well runs dry (e.g., withdraw from Roth IRAs). Tax planning remains an essential part of managing retirement assets, and helps reduce the risk of lateraturely from foolhardiness, unexpected events or simple mishap.

4. Consideration of Other Income Sources

The 4 per cent rule, for instance, refer only to withdrawal rates from retirement savings, while most retirees also receive other streams of income (from Social Security, pension benefits, annuities and the like) that reduce their need to turn to portfolio withdrawals to meet spending needs and provide peace of mind.

Alternatives to the 4% Rule

There are a number of alternative withdrawal rules that attempt to address the shortcomings of the 4% rule, among them:

1. The Dynamic Spending Strategy

Unlike the 4 per cent rule, by which spending isn’t adjusted no matter what happens to the markets, the dynamic spending strategy reduces withdrawals in bad years and increases them in good years. It’s a more responsive approach to sequence of returns risk.

2. The Guardrails Approach

The guardrails approach epitomised by Guyton and Klinger imposes upper and lower bounds on withdrawals depending on market performance: if the market does well, retirees take out more; if the market bottoms out, their withdrawals go down to limit Losing their Shirt: An Analysis of The 24 Percent Rule (1998) Guyton and Klinger’s approach has a number of critics, academic and otherwise.

3. The 3% Rule

Other experts recommend an even more conservative 3 per cent rule, especially when returns are low or retirees’ life expectancy is lengthy. The trade-off is that this dynamic has a lower likelihood of forcing people back into the workforce, but it also means either that other lifestyle changes must occur (cutting your expenses) or you will need more money in your retirement nest egg.

The 4 per cent rule is an extremely useful starting point for structuring a sustainable withdrawal from retirement savings, but it should never be applied in a vacuum. Whether modified for changing economic conditions or altered to take into account personal circumstances or life expectancy risk, care should be taken applying the 4 per cent rule. With a combination of flexibility, tax efficiency, and non-savings streams of income built into retirement planning – such as hard-earned pensions – individuals can be better prepared to weather the vagaries of retirement and ensure their savings last a lifetime.

Ultimately, however, the 4 per cent rule is only a guideline: each retiree must take stock and recheck circumstances periodically, and adjust the remaining pictures as they move through different stages of retirement.