The 4% rule for retirement: Is it time to rethink this popular withdrawal guideline?

18.07.2024 16:54

AOL.com

As you approach retirement, one of the most important questions you'll need to answer is: How much can I safely withdraw from my retirement savings each year without running out of money?

The 4% rule of retirement is a popular guideline that aims to help you answer this question and make your savings last throughout your golden years. But it’s not a perfect rule, and it’s not ideal for everyone. We also explore alternative drawdown strategies if you feel it’s not right for you.

What is the 4% rule for retirement withdrawals?

The 4% is a retirement planning rule that suggests you can safely withdraw 4% of your retirement portfolio balance each year, adjusted for inflation, without running out of money. It assumes a 30-year retirement period and a portfolio allocation of 50% stocks and 50% bonds, which is considered a moderate risk allocation.

Here's how the 4% rule works in practice:

If you have $1 million in retirement savings, you'd withdraw $40,000 in your first year (or 4% of $1 million). In subsequent years, you'd adjust this amount for inflation. You could use the Federal Reserve’s 2% target inflation rate or current inflation rates for a more accurate view of your cost of living.

Assuming a 2% inflation rate, you'd withdraw $40,800 in year two, $41,616 in year three, and so on.

The 4% retirement rule doesn't account for investment fees or taxes. Investment fees charged by financial advisors or mutual funds can eat into your returns and shorten how long your portfolio lasts.

For example, let's compare the growth of a $1 million portfolio over 30 years with and without a 1% annual investment fee, assuming a 7% annual return (and assuming no withdrawals).

As you can see, a 1% annual fee can reduce your portfolio value by more than $1.4 million over 30 years. This doesn’t include the income taxes you’ll pay on withdrawals from traditional IRAs and 401(k)s, which further reduces the amount you have available for living expenses.

???? Does the 4% rule work if you plan to retire early?

The 4% rule assumes a typical 30-year retirement. If you retire early and need your money to last longer than 30 years, this particular drawdown strategy may not work for you. (If you are planning to retire early, learn about your healthcare options as an early retiree.)

Brief history of the 4% rule

The 4% rule was created by financial advisor William (Bill) Bengen in his 1994 paper "Determining Withdrawal Rates Using Historical Data."

Bengen analyzed historical data on stock and bond returns over a 50-year period and concluded that retirees could withdraw 4% of their initial retirement portfolio balance annually, adjusted for inflation, and have a high probability of not running out of money for at least 30 years.

Since then, the 4% rule has become a widely referenced guideline in retirement planning. But it’s also been criticized, with Bengen himself saying he created the rule based on a worst-case scenario — retiring in 1969 during high inflation and a market downturn — and that it may be too conservative at times. (You can read or listen to an interview with Bill Bengen to learn how he feels about the 4% rule now.)

Who is the 4% rule best for?

The 4% rule can benefit retirees who:

Prefer a simple, easy-to-follow drawdown strategy
Want a relatively safe and predictable income stream in retirement
Have a balanced portfolio allocated to 50% stocks and 50% bonds
Expect a retirement that lasts around 30 years

Even if the 4% rule isn't perfect for your situation, it can serve as a useful starting point for determining your retirement withdrawal strategy. You can always adjust the percentage up or down based on your lifestyle and needs.

Dig deeper: How to invest your money after retirement — and make it last through your golden years

Drawbacks of the 4% rule

The 4% rule can be a helpful starting point as you plan for retirement. But it’s important to know its limitations and prepare to adapt your strategy as needed.

It can be too rigid. The rule assumes you'll spend the same amount each year, adjusted for inflation. But in reality, your spending may vary a lot. “The rule doesn’t have the level of flexibility that a retiree may need over their lifetime to live the life of joy they envisioned,” says Lawrence Sprung, CFP, author of Financial Planning Made Personal, and founder of Mitlin Financial. “Perhaps you have plans to travel extensively early on and then slow down later when you’re older. You may need more than 4% of your assets early on, or vice versa.”
It's based on the past. The rule relies on historical market data, including periods like the 1929 stock market crash and the Great Depression. But there's no guarantee that future returns will look like the past, especially with the market's ups and downs.
It may be too aggressive if inflation is high. If inflation is higher than expected, your purchasing power could erode more quickly, and the 4% rule may not provide enough income to maintain your lifestyle. For instance, in 2022, inflation hit an all-time high of 6.2% in the first half of the year and continued to stay above 4% until the end of 2023.
It ignores some key costs. “Healthcare costs are arguably one of the largest variables that may impact your costs in retirement,” says Sprung. “The higher your healthcare costs in retirement, the greater the chance that the 4% rule will not ultimately work for you.” It also doesn't account for taxes on withdrawals or investment fees — two more key costs to watch out for.
It may not work for longer retirements. The 4% rule is based on the assumption that you retire around age 65 and die around age 95. If you plan to live a longer retirement (maybe because you retire earlier or live longer), the 4% rule may not stretch your savings far enough.

Alternative strategies and modifications

If you’re going to follow the 4% rule, Sprung suggests making adjustments over time based on your retirement goals. “The 4% rule, like any rule, should be used only as a guideline,” says Sprung.

Here are smart ways and ideas for making your money last in retirement:

Stay flexible. Adjust your withdrawal rate based on market performance. In good years, take out a little more; in bad years, withdraw less. This strategy can help your portfolio last longer by adapting to market conditions.
Use buckets. Split your savings into different "buckets" for the short, medium and long term. Keep cash for short-term expenses of one to two years, bonds for medium-term expenses of three to 10 years and stocks for long-term growth of 10 or more years.
Create guardrails. Set a maximum and minimum withdrawal percentage (for example, 5% and 3%). If your withdrawal rate falls outside these guardrails because of market changes, you can adjust your spending temporarily to stay within range. That way, you avoid overspending in down markets and underspending in strong ones.
Bring in extra cash. If you need more than 4% of your retirement savings to live off of, think about other ways to increase your income — like consulting in retirement, taking on a part-time job or renting out property.

The bottom line? Be ready to adapt your plan as you go. By staying open to different strategies and checking in regularly, you'll be in better shape to make your savings last as long as you need it.

Also, don’t be afraid to talk to a financial advisor if you need help planning for retirement. An advisor’s job is to help you manage your wealth — and that includes creating a drawdown strategy for retirement.

Dig deeper: How to budget in retirement: 7 steps to maintaining your finances on a fixed income

FAQs: The 4% rule and drawing down your retirement

Learn more about retirement planning, the 4% rule and living off your retirement savings.

How long can you live on the 4% rule?

The 4% rule is designed to make your retirement savings last for 30 years. For example, if you retire at age 65 with $1 million in savings, the rule suggests you can withdraw $40,000 per year (adjusted for cost of living) until age 95. However, this assumes a specific investment mix and historical market conditions. Depending on your actual retirement length, spending habits and market performance, your savings may last longer or shorter than 30 years.

What is the 25x rule and 4% rule?

The 25x rule suggests saving 25 times your annual expenses to retire comfortably. It’s the inverse of the 4% rule, so you can use it to “work backward” and calculate how much you need to save based on your desired annual retirement income. For example, if you want to withdraw $50,000 your first year of retirement, you’d need to save $1.25 million ($50,000 x 25) to follow the 4% rule.

Why is the 4% rule outdated?

The 4% rule is outdated because it doesn't adapt to changing economic conditions. Sometimes it's too conservative — like when inflation is normal or the stock market is performing well. Other times it’s too risky — for example, when inflation is high or markets are down. The rule also doesn’t consider your individual circumstances or the type of lifestyle you want to live in retirement.

Suze Orman is quoted saying 4% is too risky and that 3% is a safer withdrawal rate. Meanwhile, Bill Bengen, the creator of the 4% rule, is quoted on a podcast in 2022 saying that 4% is too conservative and that he's upped his withdrawal rate to 4.7%.

Is a 4% withdrawal rate still a good retirement rule of thumb?

The 4% rule is a good starting point, but it may not be perfect for everyone. If you have high healthcare costs, you might need to withdraw more than 4% annually. Your retirement lifestyle also matters: If you plan to travel more in the early years, you may want to withdraw more initially and less later. Ultimately, it’s just that — a rule. You should adjust it as your needs change year to year.

Sources

Consumer Price Index for All Urban Consumers, 12-Month Percent Change, U.S. Bureau of Labor Statistics. Accessed July 17, 2024.
How Much Is Enough? Financial Advisor. Accessed July 17, 2024.

About the writer

Cassidy Horton is a finance writer who specializes in banking, insurance, lending and paying down debt. Her expertise has been featured in NerdWallet, Forbes Advisor, MarketWatch, CNN Underscored, USA Today, Money, The Balance and Consumer Affairs, among other top financial publications. Cassidy first became interested in personal finance after paying off $18,000 in debt in 10 months of graduation with an MBA. Today, she's committed to empowering people to stand up and take charge of their financial futures.