A Deeper Dive into the 4% Rule

September 12, 2017 / Blog

The 4% rule is an incredibly popular retirement rule of thumb. Part of its popularity is due to its relative simplicity: You multiply your investment account balance by 4% at retirement and that’s how much you can take out. Every year thereafter you adjust your withdrawal amount by inflation, and that’s it. Very simple.

From a very high level perspective, the 4% rule can serve as a basic guidepost for what you may be able to expect from your portfolio in retirement.

However, the 4% rule also has some very important limitations. Below we look at some of these limitations and what they may mean for you.

(if you are interested in learning more about how the 4% rule works, see our introductory post here.)



The 4% rule was never meant to be a retirement income “strategy.” It was purely an answer to a question concerning how much a retiree could withdraw from their portfolio under the historical worse case scenario. And in trying to answer that question it had to make some simplifying assumptions. Many of these assumptions make the rule unrealistic for the average retiree.

Just as a starting point, it is unrealistic to assume that someone retiring today should have the same withdrawal rate as someone that retired in 1928, 1950, or 1968, which the 4% rule does.



Constant real spending

The 4% rule assumes that you will increase your spending by inflation every year.

Mark retires with a $500,000 portfolio. He pulls out $20,000. Inflation is 3% and so he withdraws $20,600 the next year.

Economic theory assumes that most people want to smooth their consumption over time (this is known as the life-cycle hypothesis). This would make the case for constant real spending in retirement.

However, research into real world retiree spending shows that spending does not tend to increase each year by inflation. Rather, for the average retiree, spending tends to decline by roughly 1% a year in real terms throughout retirement.

Let’s take Mark again. He has $500,000 portfolio at retirement and takes out $20,000. Inflation is 3%. Based upon the average retiree, Mark would theoretically only need to adjust his withdrawal amount by 2%, not 3%. His spending decreased by 1% in real terms.

If spending does decrease throughout retirement, that would mean you may be able to start with a higher initial withdrawal rate. This is another factor that should be considered as you are creating your own retirement income strategy.


One 4% calculation

With the 4% rule you calculate 4% once and that’s it. After you make that one calculation your account balance is no longer part of the retirement income equation.

Withdrawing money without taking into account your account balance is an unnatural thing to do. If your portfolio has declined significantly you would naturally adjust spending. Same is true if your portfolio increased in value.

Most retirees won’t just spend their way down to $0, which the 4% rule assumes. And if your portfolio has doubled you most likely will want to spend some of those gains.



Importance of Starting Balance

Since the 4% rule is only calculated once (4%of the starting balance), your balance at retirement is critical.

As a hypothetical example, assume someone retirees today with $1,000,000 portfolio. The 4% rule would say that they can withdraw $40,000 from their portfolio. But let’s imagine instead that they retired after their portfolio had dropped by 20%, so the portfolio balance was $800,000. This means that they could withdraw $32,000. If they followed the 4% rule to the tee, this retiree would be destined to spend $8,000 a year less throughout retirement because of bad timing.

Unfortunately, the idea of timing risk is real. It was actually the 4% rule that brought the idea of sequence of returns risk to attention (see our post here). However with proper planning, one year shouldn’t be the sole determinant of your retirement income. Understanding sequence risk and planning for it can help alleviate some of this starting balance issue.

Along these lines, one aspect to the 4% rule that often gets lost is the importance of market valuations when you retire. As research from Michael Kitces has shown, if you retire when valuations are high (which in turn would mean your portfolio balance is higher) your safe withdrawal rate will be lower.

If you retire when valuations are lower (like the retiree who retired after his portfolio dropped 20%) then you may be able to set a higher initial withdrawal rate, such as 5%.


How do you define a successful retirement?

Its obvious that running out of money is a primary goal for all retirement planning. But, is it the only goal?

How important is it for you to maximize your spending throughout their retirement?

As Michael Kitces points out, for a retiree that followed the 4% rule, 60% of the time they would have ended up with 100% of their starting balance (adjusted for inflation) at the end of the 30 years.

If you use the 4% rule and end up leaving a lot at the end of the plan would you consider that a success? It’s a success in that you made it throughout your retirement without worrying about running out of money. But maybe it’s not a complete success in that you could have spent more of those unused funds throughout retirement (e.g. gone on more trips).

There has been a lot of research since the original 4% study that has tried to look into how to juggle this trade off. One possible answer is through the use of dynamic withdrawal rates.

In its simplest form, dynamic withdrawals allow you to adjust your spending based upon how your portfolio performs. If the market goes up over a certain %, you can adjust your spending up; if it goes down below a certain % you adjust your spending down. You can also attach “guardrails” to your spending so that you never have to adjust your spending below a set limit (a floor) or can’t adjust it higher than an upper limit (a ceiling). We described one of these approaches in our post Fixed vs Variable Retirement Spending.

Dynamic withdrawals aren’t perfect but you may be able to craft them in a way that more evenly weighs spending in retirement vs. how much is left at the end of the plan.

One of the key takeaways from the research into retirement income is the benefit of flexibility.  If you have the ability and room in your budget to adjust your spending (under certain conditions) you may be able to better achieve your financial objectives.


History as a Guide

The 4% was the withdrawal rate based upon the worst case scenario for US markets.

The only retiree that would have had to rely on just a 4% withdrawal was the 1966 retiree, as they retired into a period of poor market returns and high inflation.  All other retirees could have safely withdrawn more than 4%. For instance, a retiree in 1980 could have safely withdrawn more than 8% of their portfolio balance as they retired into a long bull market.

In fact, the original 4% study done by Bill Bengen actually showed that the median safe withdrawal rate would have been somewhere around 6%-6.5%.

We unfortunately don’t know what future returns will be and, more importantly, in what order they will occur. Will you retiree into an environment like 1966 or 1980? Or maybe something completely different?

Another aspect to this is that the 4% rule was only based upon historical market returns for the US stock and bond markets. Research by Wade Pfau showed that safe withdrawal rates for most other countries was much lower than 4%.


Final Thoughts

The 4% rule can have its merits as a basic guideline for what you may be able to pull from your portfolio in retirement. However its unrealistic to use the 4% rule as your primary retirement income strategy. Retirement income planning isn’t an exact science and there is no one “safe withdrawal rate.”

There are a number of different ways to build a retirement income plan. The best one is the one that is personalized for you.



About the author

John Shanley: CFP ® is a Financial Advisor with Pinnacle. He joined in 2015 after previously working as a Financial Consultant for Fidelity Investments. John is a Certified Financial Planner, a graduate of Fordham University and is currently pursuing his Masters degree in Financial Services. John is a native of Pawling NY and currently resides in Suffield with his wife, Jennifer, who is an Immigration Attorney. In his free time, John enjoys reading and is an avid hockey fan.