Let’s dive deeper into the 4% rule, learn how it works, how to use it to manage your retirement withdrawals, and explore a few caveats to the rule.
What Is the 4% Rule of Thumb?
As the name implies, this rule of thumb asserts that withdrawing 4% of your retirement savings each year (adjusted for inflation after the second year) is the best way to ensure your retirement funds won’t run out before 30 years.
Where Does the 4% Rule of Thumb Come From?
The rule is based on a 1994 study by William Bengen, an investment management specialist, who explored sustainable withdrawal rates for retirement portfolios. In the study, Bengen examined withdrawal rates for 30-year rolling retirement periods from 1926 to 1963. The test determined that 4% is the highest initial withdrawal rate that would allow the retirement portfolio to last a full 30 years, regardless of market conditions.
How Does the 4% Rule of Thumb Work?
If you retire with $1 million in your portfolio, you’d withdraw $40,000 in the first year, according to the rule. Going forward, you’d withdraw $40,000 plus inflation. If inflation in year two is 3%, for example, you would withdraw $41,200. The additional $1,200 compensates for inflation, ensuring you can maintain your standard of living. Keeping your portfolio invested during retirement allows you to earn an average return over time. In theory, your investments will grow, preventing you from depleting your funds too quickly.
Grain of Salt
Though the 4% rule can be helpful for retirement planning, it has some drawbacks and won’t work for every retirement scenario. Some experts criticize the rule as being too risky. The 4% rule assumes the retiree maintains a balanced portfolio of 50% common stocks and 50% immediate-term Treasurys. However, Charles Schwab suggests reducing exposure to stocks in retirement in favor of a mix of cash, bonds, and stock. Also, past market performance is not predictive of future results. The research behind the 4% rule assumes a 10.3% stock return, a 5.2% bond return, and a 3% inflation rate. Some analysts question whether we can expect the same returns in the future. The 4% rule also assumes the retiree’s expenses are consistent from year to year, increasing only with inflation. In reality, spending could vary from one year to the next. The rule assumes a 30-year horizon, which may not be the best fit for everyone depending on the initial retirement age and life expectancy. The Social Security Administration estimates the average life expectancy for someone turning 65 in 2021 is about 20 years, 10 years under the 4% rule’s time horizon. In a situation where there are low returns and high inflation, following the 4% rule means higher withdrawals. This could deplete the retirement savings faster. Retirees may have to break the rule and withdraw less money. Bengen suggests doing this whenever the current withdrawal amount exceeds the first withdrawal amount by more than 25%.
4% Rule of Thumb vs. $1,000-a-Month Rule of Thumb
The $1,000-a-month rule is another strategy for sustainable retirement withdrawals. The rule assumes you start with $240,000 retirement savings and withdraw $12,000 each year for 20 years, or $1,000 per month. For this rule, you would either need a low cost of living or additional income to supplement your $1,000 monthly withdrawals. It doesn’t compensate for inflation or annual cost-of-living increases, nor does it consider retirements that last more than 30 years.
4% Rule of Thumb vs. 25x Rule of Thumb
The multiply by 25 rule isn’t a retirement withdrawal rule of thumb, but it is sort of a prerequisite to the 4% Rule. The 25X rule says that if you save 25 times your desired annual retirement salary, you can withdraw 4% of that amount each year and it will last 30 years.
