Retirement and Financial Independence

The 4% Rule: Is It the Superior Retirement Planning Strategy?

Updated on June 4, 2020 Updated on June 4, 2020
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Planning, discipline, and, of course, saving are all needed to fund a retirement. But what happens when it’s time to retire? How much can you spend each year? How can you make sure you don’t run out of all the money you saved?

The 4% Rule emerged in the 1990s as a popular tool to fortify the longevity of retirement accounts. It’s since garnered changes and critiques to better inform decision-making but remains a go-to rule of thumb for retirement planning.

We’ll examine the pros and cons of the 4% Rule and how you can use it to guide your golden years.

What Is the 4% Rule?

Financial adviser William Bengen developed the 4% Rule as a strategy for retirement portfolio management. It’s simplicity quickly made it a popular rule of thumb to manage retirement withdrawals.

Bengen designed his strategy around a single retirement account, like an IRA or 401(k), not a diversified mix of accounts and assets. This approach ensured the account would provide a steady stream of retirement income for 30 years.

The initial withdrawal amount in the first year of retirement is 4%. After that, every annual withdrawal rate is set to that same initial withdrawal amount plus the cost of inflation.

To be clear: you do NOT take out 4% of your account balance each year. You use 4% of the portfolio’s balance in the first year to establish a base for each subsequent year’s withdrawal.

The 4% Rule intended to provide a steady stream of income while reserving a large enough balance that will produce investment returns. These returns (ideally) extend the life of the account for 30 years.

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How Does the 4% Rule Work?

Let’s say you your 401(k) has $100,000 in a Roth IRA. In year one, you’d withdraw 4% which is equal to $4,000. You’d calculate it this way:

100,000 x .04 = 4,000

Now, that $4,000 is your base. Every year, you will take out $4,000 plus an additional adjustment for inflation.

The Bureau of Labor Statistic’s Consumer Price Index (or CPI) is the most common data source used to measure inflation. They have annual CPI data dating back to 1913. The below table is a sample of how you can do it.

YearInflation RateInitial WithdrawalInflation MultiplierWithdrawal Amount
22.5%$4,000x 1.025$4,100
32.7%$4,000x 1.027$4,108
41.8%$4,000x 1.018$4,072
52.1%$4,000x 1.021$4,084

The formula continues each year for 30 years. That’s it. No complex number crunching or worrying about the ups-and-downs of the market.

It’s easy to see why it became so popular.

What Are Its Assumptions?

The 4% Rule is based on several assumptions that drive the formula. They have also garnered critiques over the years for their rigidity.

Let’s lay them out to better understand the underlying principles.

30 Year Time Period  

The 4% Rule is for a 30-year retirement, so, technically, it won’t last forever. That’s why it’s important to consider your life expectancy as part of your retirement savings plan.

60/40 Asset Allocation

The 4% Rule assumes the account’s allocation is 60% invested in the stock market and 40% invested in bonds. If your account is distributed differently, it may throw off the rule’s effectiveness.

Historical Market Performance

Bengen sought to better understand how past market trends would affect a retirement portfolio. He used historical data starting in 1926 to the mid-90s to examine year-to-year trends instead of relying on average market performance.

This was comprehensive at the time but doesn’t account for changes in the market over the past 25 years.

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Is the 4% Rule Safe?

Well, technically speaking: no. Nothing is truly safe in the investment world.

The 4% rule popularized the idea of the Safe Withdrawal Rate to determine a sustainable withdrawal rate to last the length of your retirement (i.e., the rest of your life).

Today, there are a variety of strategies to determine that number. But they are all relative.

The 4% Rule and other Safe Withdrawal Rate strategies analyze historical data to assess future market conditions.

Bengen found a 4% rate was able to ride out the most volatile trends in the past, and thus recommended applying it to the future as a conservative approach.

But it’s impossible to predict market volatility, how it will react to bear markets, or high periods of inflation. That’s out of your hands.

Investing is still the best proposition for your money even though it’s risky. Withdrawals from your accounts are in the same territory.

The 4% Rule’s analysis of historical data provides a reliable, conservative predictor of future trends, even if nothing is guaranteed.

4% rule

 

Does the 4% Rule Account for Inflation?

Yes. One of the main drivers of Bengen’s analysis was understanding inflation’s impact on retirement spending.

The 4% Rule includes a yearly inflation adjustment to maintain your retirement income’s purchasing power.

This allows the withdrawal rate to adjust to the increased cost of living caused by inflation. You could consider using the Federal Reserve’s target inflation goal of 2% annually for more consistent planning as an alternative.

The consistency would be offset by the risk of losing purchasing power when inflation outpaces the Fed’s target goal.

Is the 4% Rule Outdated?

You don’t have to be a rocket scientist to appreciate how much the world has changed since the mid-90s. Many studies and blogs have reasonably identified several flaws in the 4% Rule you should consider as you prepare for retirement.

Retirement Isn’t Stagnant

The 4% rule was purposefully designed in a vacuum. The assumptions and math are all positioned to achieve one concrete goal: a sustainable withdrawal rate to last 30 years.

But that goal may not fit your needs. A comprehensive withdrawal strategy should consider your age, income, and wealth. The 4% Rule does NOT consider these factors.

Life – and retirement – don’t happen in a vacuum.

The 4% Rule doesn’t account for changes in your income needs either. It’s one set withdrawal.

What if you planned to travel early in your retirement? How will your healthcare needs change?

What if you live longer than 30 years? How will inflation and interest rates change?  What about your tax obligations?

And there are still more questions to ask that can’t be answered by the 4% Rule. You should consider the 4% Rule in the context of such questions.

Navigating Retirement Today Is More Complex

Bengen’s historical analysis of bond rates provided for a 5% return. That isn’t the reality for today’s world.

While you can’t predict the future, increased market volatility over the past 20 years has led to skeptics in the rule’s performance.

You should also consider how Social Security will impact your retirement. Your ability to defer Social Security will impact how much you qualify for and, conversely, how much retirement income you’ll need from your portfolio.

Changes to Social Security, in the long run, could further impact the rule’s effectiveness.

Today’s tax code is much more complicated as well, especially for various retirement accounts. Most people have a variety of retirement accounts in their portfolio each with different tax obligations.

You may have different sources of income like rental properties with separate costs and tax obligations.

Your income bracket also affects taxes as they incrementally increase with income. Higher-income retirees also need to consider the Medicare surcharge and minimum required distributions, among other requirements.

Again: the 4% Rule operates in a vacuum and life doesn’t.

Too Little or Too Much?

Bengen himself has noted that the model isn’t perfect. He even updated his recommendation to 4.5% in a 2017 Reddit Ask Me Anything.

Estimates now range between 4.1% to 4.5% depending on your target time horizon. It also comes down to personal philosophy.

Are you comfortable being conservative and risking having money left over to pass on when you’re gone?

Using 4% as your guide is probably still useful.

If you’re aiming to get the most out of your accounts, 4.5% may be a more aggressive (or effective, depending on your point of view) approach to the withdrawal rule.

As Frank Eberhart said, “the goal of retirement is to live off your assets, not on them.” Perhaps a financial planner advises you that 5% is better suited to your assets and age.

Refine the Assumptions

The bottom line: The 4% Rule is a simplistic view of retirement. Bengen’s adjustment of his own rule is an indication it should be a guide instead of doctrine.

Try refining the assumptions to fit your retirement planning.

The 4% Rule isn't outdated as a rule of thumb.

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While 4% as a number may be outdated, the idea behind the rule – having a consistent strategy – is still relevant. Just like proper budget planning, determining a plan and sticking to it is crucial.

Does the 4% Rule Work for Early Retirement?

An early retirement – whether you’re diving headfirst into the FIRE movement or just planning to cash out a few years early requires detailed attention to managing your portfolio’s longevity.

The 4% Rule is designed to last 30 years. Some would say it’s prudent to withdraw less, given the longer time involved with early retirement.

Others would argue a 4% withdrawal rate is conservative as is given the changes in the market. You’ll need to consider the mix of your income and assets as well as your risk tolerance to find your number.

Early retirees and FIRE devotees should consider how to leverage alternative assets for diversified income streams. You don’t want to deplete your savings with years (or decades) remaining.

Consider talking with a financial planner to help prepare your portfolio for early retirement.

How Much Money Will I Need for Retirement?

The 4% Rule can also be a helpful rule of thumb to determine how much you’ll need to save for retirement. Use your annual budget and reverse the formula to determine your nest egg goal.

Let’s say you estimate you’ll need $50,000 per year to live comfortably. You’d divide 50,000 by 4%. The math looks like this:

50,000 / .04 = 1,250,000

With a little back-of-the-envelope math, you’ll need $1,250,000 saved by the time you retire to live off of $50,000 a year. It’s never too early to start saving for retirement.

Of course, this doesn’t consider social security, taxes, and all the other caveats that will affect your final retirement income stream.

Betterment has an easy-to-use retirement calculator that can help you craft a more precise savings plan. Still, a little quick math never hurt.

A Helpful Rule of Thumb

A rule of thumb is more suited to a bit of back-of-the-envelope math. That’s the 4% Rule in a nutshell.

It’s not intended to stand up to modern standards of market analysis and financial planning. But it shouldn’t be thrown out the window.

The 4% Rule can be a helpful tool to give you an overview of how much you’ll need to retire and the lifestyle you can afford.

Consider talking with a financial planner or use some personal finance tools to design a plan reflective of your needs and risk tolerance. Until then, you can use the 4% Rule to get a basic sense of the big picture.

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Mike Uberti - Contributor Mike Uberti is a personal finance writer, researcher, and municipal government policy analyst and project manager. His passion for the almighty dollar was sparked by a graduate course he took in college. Since then, he's used that knowledge to successfully fund his education, buy a home, and save for retirement. Mike received a Masters in City Planning from UC Berkeley and lives with his wife in Oakland, California. In his free time, he contributes to his IRA.
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