The 4% rule in retirement has been around for several decades, and it remains a powerful tool that can help you predict how much you can withdraw from your retirement savings each year without depleting your savings too quickly or running out of money before you die.
There are some downsides to the 4% rule, but overall it’s still a solid choice if you want to retire early and live off of your savings safely.
Here’s what you need to know about the 4% rule in retirement before deciding if it’s right for you.
What is the 4% rule?
As its name suggests, the 4% rule is used to determine how much a retiree can withdraw from their savings each year without running out of money.
Essentially, it states that you can safely withdraw 4% of your portfolio each year if your investments are diversified between stocks and bonds.
The amount is adjusted for inflation (although the adjustments may not always be accurate) but because the method assumes that your portfolio will decline by about 3% per year—due to inflation, taxes, etc.—you’ll still be able to maintain a sustainable income stream.
It isn’t without risk; if you live a long life or don’t adjust your spending properly to account for inflation, there is the potential that you could run out of money when you die.
The Origins of the 4% Rule
The 4% rule was developed by Bill Bengen, a retired engineer who wrote a paper on safe withdrawal rates back in 1994.
He researched historical US stock and bond market data going back to 1871 as well as looked at potential pension payouts for military personnel.
His findings showed that retirees could sustainably withdraw about 4% of their retirement savings every year without running out of money.
The main assumption of his study is that if you withdraw less than your annual spending goal from your portfolio, you’ll use up its principal—which means your future retirement income will be reduced.
However, his research doesn’t take into account other variables such as how long you live or unexpected costs during retirement.
Why do some financial experts question it?
It’s called the 4% rule, which means retirees can withdraw four percent of their nest egg for every year they plan to live without tapping into their principal.
If a retiree lives to be 80, for example, he or she can theoretically draw down 26 percent of his or her nest egg each year.
There are some financial experts who question it.
They say that people often underestimate how long they’ll live, which can cause many retirees to run out of money.
And there is no way to know if you will have an average life expectancy.
Some individuals will end up living longer than expected while others will pass away sooner than expected.
Financial experts have found that there is no way to accurately determine an individual’s life expectancy.
So using a withdrawal rate of 4 percent could put people who live longer at risk of outliving their savings.
You can use any online retirement withdrawal calculator, using the 4% rule as the amount you intend to withdraw annually, and test it.
Financial experts recommend that retirees calculate how much they’ll need each year in retirement and decrease their rate of withdrawal when they’re closer to death.
One such recommendation is known as the 3 percent rule, which means that retirees should scale back withdrawals if they are older than 71 years old or have less than 25 times their annual expenses saved up by that age.
Another strategy would be for retirees to consider dividend-paying stocks or bonds to supplement their income.
Unlike interest from bonds, dividends from stocks can continue indefinitely even after a stock has reached its maturity date.
What are some pros and cons of the 4% rule in retirement?
While following the 4% rule can make it more likely that your retirement savings will last the remainder of your life, it doesn’t guarantee it.
For example, if you withdraw too much from your portfolio one year because you’re not sure how long you might live, you could run out of money before you die.
Similarly, if market returns are low for a few years in a row (which is possible), then it could be difficult to meet those withdrawal targets without selling investments at a loss—and losing money on what was supposed to be an income stream.
The 4% rule has pros and cons. Here are some:
Pros
- It’s simple to follow. If you have $1 million, withdraw $40,000. If you have $2 million, withdraw $80,000.
- Provides predictable, steady income. You know what you’ll be withdrawing each year. If your investments don’t perform as well as expected, you can always cut back.
- Historically, protects you from running out of money in retirement. It’s been shown to work over a 30-year period.
- It’s flexible. If your investments perform better than expected, you can withdraw more.
Cons
- It doesn’t include taxes or investment fees. If you withdraw more than $40,000 from your investments, you’ll pay taxes on that amount.
- It doesn’t account for inflation, which can eat away at your savings over time. For example, if you have $1 million to retire on and plan to withdraw $40,000 per year, you’ll run out of money after 29 years if there’s 3% annual inflation.
- It doesn’t account for medical expenses. If you’re going to live a long time, you’ll likely have to pay more out of pocket for healthcare.
Does the 4% Rule Still Work?
While the 4% rule has been used as a guideline for retirees since the 1990s, its calculations could change.
The 4% rule is considered safe by most experts as long as you start saving early enough.
But your nest egg needs to last through 30 years of retirement.
If you were born after 1965, your golden years might extend into your 90s!
For people who live longer than expected, the 4% rule might not work out so well.
To be safe, retirement savers should consider increasing their withdrawal rate during periods of low-interest rates or lower-than-expected stock market returns.
To figure out whether to change your spending habits, first decide if you’re saving enough for retirement.
After all, you can’t spend more than you have.
If your current savings rates won’t put you on track to retire on time, talk to a financial advisor about ways to boost your retirement income.
He or she may be able to recommend more than one solution so that you choose an option that fits your current lifestyle without jeopardizing your financial future.
Should you use the 4% rule in retirement?
With the 4% rule, a retiree can take out 4% of his/her savings in the first year of retirement.
Then, in subsequent years, the retiree can use that year’s inflation rate to adjust the amount withdrawn up or down.
If you look at historical returns on investments, you’ll see that withdrawing 4% shouldn’t cause problems in most cases.
However, there’s no guarantee your portfolio will hold up as it has in the past.
If you’re retiring soon, it might be tempting to rely on historical data to make your retirement planning decisions.
But, as John Wasik wrote in a Forbes column, it’s best to use more recent numbers to predict future performance.
This is because our country’s population is aging quickly.
This means that most portfolios will have at least some weighting of bonds instead of stocks going forward.
As bond yields rise over time you could see your portfolio’s annual returns drop below 4%.
If you don’t want to risk having no money in your retirement, consider allocating your portfolio toward safer investments.
Just remember that lowering risk generally results in lower returns.
