The 4% rule serves as a retirement withdrawal guideline suggesting retirees withdraw 4% of their retirement account in the first year, adjusting that amount annually for inflation. This approach is designed to sustain funds for roughly 30 years, leveraging investment returns to generate a steady income stream from interest and dividends. However, this rule may not be suitable for early retirees needing income over an extended period. While Bill Bengen, the creator, suggests 5% could be viable in most cases, other financial advisers propose a more conservative 3% withdrawal rate. Ultimately, the rule's effectiveness varies based on individual circumstances and market conditions.
Planning Retirement Withdrawals with the 4% Rule
Many financial planners and retirees use the 4% rule to estimate a comfortable yet safe retirement income. An important factor for its success is life expectancy. Retirees who live longer or retire early need their portfolios to last longer, and increasing medical and other expenses can arise with age.
A Look Back: The Background and Progression of the 4% Rule
Developed by financial adviser Bill Bengen in the mid-1990s, the 4% rule is based on historical stock and bond data from 1926 to 1976, specifically focusing on downturn periods in the 1930s and 1970s. Bengen found that, even in the worst market conditions, a 4% annual withdrawal rate did not deplete a retirement portfolio in less than 33 years.
Adjusting the 4% Rule for Inflation
To maintain purchasing power, retirees can adjust their 4% withdrawal rate for inflation. This can be done by setting a flat annual increase of 2%, matching the Federal Reserve's target inflation rate, or by adjusting withdrawals based on actual inflation rates. The former offers predictable increases, while the latter aligns more closely to actual cost-of-living changes.
Pros and Cons of the 4% Rule
Adhering to the 4% rule can increase the likelihood that your retirement savings will last throughout your life, but it does not guarantee it. The rule is built on historical market performance and may not predict future trends. What was once a safe investment strategy might not hold in changing market conditions.
- Pros:
- Simple to follow
- Provides a predictable, steady income
- Helps protect against outliving savings
- Cons:
- Demands strict adherence
- Built on a "worst-case" portfolio performance
- 5% might be a more practical figure
Performance of the 4% Rule During Economic Downturns
Financial planner Michael Kitces highlights that the 4% rule considers severe downturns like 1929 and has performed well during recent crises. Kitces indicates that retirees in the 2000s and 2008 financial crises have done comparably well or better than those in previous adverse conditions. He advises against withdrawing more than 4%, emphasizing safety for retirees. While some experts suggest a safer 3% withdrawal rate due to low interest rates on bonds and savings, the optimal strategy includes consulting a financial planner to review individual circumstances, savings, current investments, and retirement plans.
