The 4% Rule: Is It Good Enough?

It’s the question on the mind of every potential retiree. How much of your nest egg can you withdraw every year without running out of money in retirement?  In 1994, William Bengen attempted to answer this important question. Mr. Bengen published his research in a groundbreaking article entitled “Determining Withdrawal Rates Using Historical Data” in the Journal of Financial Planning in October 1994.

The study analyzed historical market data over a 50-year period between 1926 and 1976. The study looked at various withdrawal rates of theoretical portfolios ranging from 50% stocks/50% bonds to 75% stocks/25% bonds. The time period reviewed in this study included the Great Depression of 1929, World War 2 and the recession of 1973 (and its associated high inflation rate).

Bengen then calculated how long these portfolios would have lasted with withdrawal rates of 3%, 4%, 5% and 6%. With a 3% withdrawal rate, all portfolios lasted at least 50 years. With a 4% withdrawal rate, the vast majority (80%) of the portfolios lasted at least 50 years. All of the portfolios lasted at least 33 years.  At 5%, more than half of the portfolios failed in less than 50 years, with the 20 years as the worst-case scenario. At 6%, 20% of the portfolios lasted less than 20 years.

Most Americans, retiring in their 60’s, should assume a retirement period of 30 years or more. For this reason, most focus on the 4% withdrawal rate described by Bengen. Those following the FIRE (Financial Independent Retire Early) movement with a potential 50-year retirement would be wise to assume a 3% or 3% initial withdrawal rate.

Millions initially utilize the information in this study not as a withdrawal strategy, but as a way to determine how much to save prior to retirement, by dividing their estimate annual expenses by 4% (or 0.04). Once these individuals retire, it’s time to decide if the 4% Rule will also be used as their retirement withdrawal strategy.

So, is this simple, straightforward strategy good enough to utilize as your withdrawal strategy?

Since its creation, the pros and cons of the 4% Rule have been hotly debated. The pros of the withdrawal strategy include:

1. Simplicity: The 4% Rule is easy to follow. Once retired, withdraw 4% of your portfolio’s value. The following year, the withdrawal amount is increased by the previous year’s rate of inflation. The advantage of this methodology is that the retiree’s buying power is preserved year after year. Assuming a $1,000,000 portfolio and an inflation rate of 3%, the retiree would withdraw $40,000 the first year. The following year, the withdrawal amount would be $41,200 (103% of the previous year’s withdrawal). The math and decision-making process could not be easier. No adjustments are necessary based on your portfolio performance.
2. Historical Success: The withdrawal rate of 4% was chosen for its 100% historical success rate over all 30-year retirement periods beginning in 1926 including some of the countries worst financial periods.
3. Inflation Adjusted: The 4% Rule includes annual inflation adjustments maintaining the retiree’s buying power for the duration of the retirement. However, these annual adjustments may actually overcompensate for actual spending since annual retirement spending trends to actually decrease 1% to 2% annually for the first fifteen years of retirement. This fact may make the 4% Rule too conservative.

Critics of 4% Rule list the following cons:

1. Independent of Market Conditions: Critics note that no adjustments are made to annual withdrawals in the face of sever market downturns. Proponents consider this to be strength contributing to the simplicity of method.
2. Limited to a 30-year retirement: The method assumes a retirement of no more than 30 years. Remember, 20% of the theoretical portfolios studied failed between years 30 and 50. The 4% withdrawal rate may not be appropriate for those retiring early with a retirement period greater than 30 years.
3. “Historical returns may not be indicative of future performance”; Every investor is familiar with this common disclaimer. There may be a situation in the future that does not support a 4% withdrawal rate for 30 years. However, a 50-year review resulted in a 100% historical success rate.
4. Taxes: The 4% Rule does not take taxes into account. The retiree will need to pay any taxes incurred from the annual withdrawal.

It is also important to remember that the 4% Rule is a ‘worst case scenario.” In fact, almost 75% of the portfolios increase in value over the duration of retirement with the average portfolio increasing to 140% of its original value. Some look at this fact as an advantage of the method. This withdrawal method usually leaves a large portfolio as legacy to your heirs. Others, particularly those without heirs, point out that a lot of money is usually left on the table.

Since Bengen’s study, a number of withdrawal strategies have been developed attempting to improve upon the strategy and overcome the potential shortcomings of the 4% Rule. Dynamic withdrawal strategies, for instance, offer flexibility by adjusting spending in response to changes in market performance or portfolio value. Some of these dynamic withdrawal strategies have the advantage of supporting a higher withdrawal rate, at least initially. Such approaches aim to maximize income while preserving the longevity of the retirement portfolio. The downside to many of these approaches is their perceived complexity.

Moreover, some retirees opt for a hybrid approach, combining the principles of the 4% rule with other strategies to mitigate risks and enhance flexibility. Many retirees that attempt to navigate the complexities of these dynamic withdrawal strategies often return to the 4% Rule because of simplicity.

The 4% rule remains a valuable tool in retirement planning, offering a structured, simple framework for determining withdrawal rates and managing portfolio sustainability. However, it is not without its criticisms and limitations, necessitating a nuanced understanding and consideration of alternative strategies.

The bottom line is that the 4% Rule has worked well when back tested and will likely continue to  work well for the vast majority of retirees. It can initially be used as a rule of thumb to calculate the size of the nest egg necessary to retire. It can then be used as a simple, reliable withdrawal strategy for the vast majority of retirees balancing a reasonable withdrawal rate with maintenance of buying power for the duration of your retirement and leaving a legacy for your heirs.