The 4% Rule for Retirement: Guide to Safe Withdrawal Strategies
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Reading time: 8 minutes
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Introduction
Wondering how long you need to work before reaching financial independence? How much money do you need to retire? How much money can you safely withdraw from your portfolio in retirement? If you don’t have a clear answer to these questions, then this post is for you.
Our personal finance blog is dedicated to boosting financial literacy and guiding you toward financial independence and early retirement. The simple idea behind reaching financial independence is to save as much as you can and to invest it, so you can eventually live off those investments without being dependent on employment. For most, this occurs at the traditional retirement age, where a person exiting the workforce is able to live off a combination of pensions, savings, and investments. However, for those who plan ahead this can be achieved much sooner.
But how much money do you really need, either to retire or, at least, to consider yourself financially independent? The widely-used 4% rule is a popular financial strategy to determine how much money you need for a comfortable and secure retirement. In today’s post, we outline every important aspect you need to consider when it comes to using the 4% rule. Specifically, we address the following questions:
What is the 4% rule and where did it come from?
Why does anyone need a “rule” in the first place?
How does the 4% rule work in practice?
Caveats to using the 4% rule
Under what circumstances can applying the 4% be helpful?
Updates to the 4% rule
How can we improve the 4% rule in practice?
What is the 4% Rule and Where Did It Come From?
The 4% rule is a spending rule that is used widely within the personal finance space to determine how much you can spend sustainably from your portfolio in retirement to avoid running out of money in your older years. As the name implies, it suggests that you can safely withdraw 4% of your savings portfolio in the first year upon retirement.
The 4% rule, created by financial expert William Bengen in 1994, is a key principle in retirement planning, who analyzed historical large cap stock and bond market data to determine a safe withdrawal rate for retirees, i.e. how much you can sustainably take out from your portfolio each year. He found that a 4% withdrawal rate, adjusted annually for inflation, would have sustained a retirement portfolio for at least 30 years, even during periods of strong market downturns.
The study looked at a wide combination of asset allocations, ranging from 100-0% stocks/bonds to 0-100% stocks/bonds, and at different safe withdrawal rates. It then tested the success rate (i.e., not running out of money after 30 years) of each of these asset allocation strategies to different portfolio withdrawals rates (e.g., 3%, 4%, 5% etc.) for the 1926-1976 period (50 years). This means testing what would have happened to each combination of withdraw rates and asset allocation strategies for someone retiring for 30 years in each of the years of the 1926-1976 rolling period. If this sounds confusing, take some time to understand some of the results of the study that are presented below in Table 1.
The 4% withdrawal rate did exceptionally well for asset allocations of up to 50-50% stocks/bonds, as observed in Table 1. And this is where the myth was born: for a 30 year period, you can expect to safely retire with a portfolio of 50-50% stocks/bonds and sustainably withdraw 4% each year (adjusted for inflation) without fear or running out of money. Of course, the 3% withdrawal rate did even better (see Table 1), but using a lower withdrawal rate also means working many more years to reach a larger portfolio before being able to retire.
Table 1. Portfolio success rates from the original study. Columns refer to scenarios that use different withdrawal rates (3%-10%), while rows consider different stock/bond asset allocation strategies.
Why Does Anyone Need a “Rule” in the First Place?
One of the most dangerous risks retirees face is being exposed to sequence of return risk. If you are unlucky to retire in a “bad” year, where you have 2-3 years in a row of poor (i.e., negative) market returns, there is a significant risk that your portfolio may not be able to recover and safely sustain you in retirement. The 4% rule was originally thought of for workers exiting the workforce at the traditional retirement ages of 60-65. These retirees were hopeful about potentially enjoying a 30 year retirement and wanted to ensure they didn’t run out of money during this period.
How to Apply the 4% Rule in Your Retirement Planning
Let’s suppose you are 65 and ready to retire. You have $1M dollars invested in your portfolio, a combination of stocks (low cost index funds) and bonds. Your withdrawals would take place as follows:
Year 1: you withdraw $40,000 (4% of $1M)
Year 2: you withdraw $41,200 (adjusting for a 3% inflation that took place during year 1).
Year 3: you withdraw $42,024 (adjusting for a 2% inflation that took place during year 2)
Rinse and repeat for the following years of retirement.
Caveats and Considerations to Using the 4% Rule
When should we be careful using this rule? In short, always. The very creator of the 4% rule suggests this should be thought of more as a rule of thumb, not a rule of nature. It is important to pay attention to the small print and caveats, which are presented below. But more generally, it is not a good idea to blindly withdraw money from your portfolio following any approach that is too rigid. There are better, more flexible withdrawal strategies to optimize your retirement portfolio, which are briefly elaborated on in a subsequent section below.
First, the 4% rule might not be ideal for early retirees, who need a tailored financial strategy to account for longer retirement periods. It is important to note that the study the 4% rule is based on was targeting traditional retirees with a 30-year retirement horizon. However, nowadays more and more people, particularly Gen Z (born during 1997 – 2012) and millennials (1981 – 1996), increasingly report not being sold to the traditional 40-year, 9-to-5 career pathway that previous generations followed. Anyone wishing to retire early should view this rule with special care; early retirees should consider that their retirement horizon could be significantly longer, requiring a sustainable financial plan that accounts for extended life expectancy.
Second, the 4% rule calls for an aggressive investment strategy that not all investors are comfortable with. Everybody’s investing risk tolerance is different. Asset allocations of stocks/bonds ranging from 75-25 to 50-50 are perceived as aggressive by many. It is important to remember that having a large share of your wealth in a volatile asset class like stocks calls for a perfect behavior from the investor: he or she must be very disciplined and avoid selling when markets fluctuate strongly every few years.
Third, the original Trinity study used US data only. Subsequent studies have examined how the 4% rule would have performed historically outside the US. Surprisingly, although it worked in the US, Canada, and Australia, it was unsuccessful in 18 other countries of the dataset. You shouldn’t be investing only in your home country in the first place (research more on “home country bias”), but if you are, then the 4% rule simply doesn’t apply to your situation.
Fourth, the study ignored taxes and fees, but you shouldn’t. Taxes should be considered as part of the expenses you want to fund in retirement within the 4% withdrawal. If you pay fees in the context of actively managed funds, remember to also consider this as part of your retirement expense.
Photo by Sacha Verheij on Unsplash.
Under What Other Circumstances Can Applying the 4% Be Helpful?
In spite of the caveats, considering the “4% rule” can be incredibly powerful at the start of your wealth accumulation phase. For those starting their investment journey or working toward financial independence, it can serve as a compass when trying to respond to the question of how much money do you really need to be financially independent or able to retire. Most people are clueless of what “their number” is.
Consider the following example to assist you in calculating your financial independence number. If you think you will need $50,000 per year to sustain your lifestyle comfortably in retirement, then you would need to have accumulated around $1,250,000 in your portfolio by the time you decide to exit the workforce ($50,000 / 0.04). At the beginning of your investing journey, this information is more than enough to motivate you and to get started with investing. You will have plenty of time on the way to learn about the nuance surrounding safe withdrawal rates.
Updates to the 4% Rule.
For those that feat that a 4% withdrawal rate is too risky, consider that Bill Bengen recently updated his “rule” to 4.7%, after considering a more diversified set of asset classes in his portfolio that critically included small cap stocks. The best asset allocation of stocks in his updated research was between 55% and 60%. If you lower your allocation of stocks under this point, you don’t get enough returns; if you increase it too much, the volatility of the portfolio reduces the withdrawal rate.
How to Adapt and Improve the 4% Rule for Modern Retirement
With one word, flexibility. It is important to stress this: you absolutely need to pay attention to what the market is doing and adapt your spending accordingly. You don’t have to do this on a 1:1, ratio i.e., if the market goes down 20%, you don’t need to reduce your spending by 20%, or vice versa. But you do need a buffer for both cases. Better withdrawal “rules” should consider variable spending strategies.
My favourite variable spending strategy is to follow the Guardrail Strategy, as suggested by Michael Kitces, a financial advisor. In practice, this means withdrawing within a safety lane that is limited by 2 guardrails that allow you to modify your withdrawals if the market is performing either very strongly or very poorly. We will cover this strategy in detail in a subsequent blog post.
Final Considerations.
Before letting you go to read another post or watch one of our videos, consider as well these final important points:
Critics of the 4% rule for early retirees often overlook key facts: 1) if someone managed to accumulate a retirement portfolio a few decades earlier than everyone else, he or she will have demonstrated a great deal of discipline and good financial habits. That person can and will adapt to market conditions as needed. 2) If you retire early and you need to go back to some form of employment (even part time, or doing something you enjoy) it will not be the end of the world. 3) Remember that most people will want to stay active and will likely continue to contribute to society in some form or other, which in many cases will also lead to some additional sources of income. 4) Unplanned inheritance and other unexpected windfalls can also supplement your retirement income and boost financial security.
Keep in mind that expenses change over time in retirement. People tend to underestimate their initial spending and overestimate spending in later years. Considering the whole retirement period, someone retiring at 65 will likely spend less on aggregate than the 4% rule would suggest. For a traditional retiree, the 4% rule is a very conservative strategy to follow.
Enjoyed this post? Don’t miss our insights on flexible withdrawal strategies for early retirement and our post on the importance of index funds in your financial independence journey.
