What’s the 4% Rule?
Put simply, the 4% rule is this: You can safely withdraw 4% of your investment portfolio annually without running out of money.
Where did this rule come from, can we trust it, and how do we apply it?
In the 1990’s, William Bengen attempted to address the uncertainties surrounding retirement. Folks were getting to retirement and then they were scared to withdraw from their retirement accounts because they didn’t want to run out of money. Folks were attempting to save for retirement but had no idea how much they actually needed.
Haven’t you ever wondered: How much do I need to save for retirement?
Bengen arrived at the 4% rule. He took historical data and found that, over every 30-year run in the history of the stock market, if an investor withdraws 4% of the first years’ portfolio balance every year, they would never run out of money.
For example, if an investor had $1,000,000 invested in their portfolio the year they retire, they can then withdraw $40,000/yr to live on. This withdrawal rate will assure that they have enough money for a 30-year retirement.
Portfolio Value (P) x 4% = Annual Withdrawal Amount (A)
How is this possible?
The stock market has historically had an inflation adjusted annualized average rate of return of 10% year over year (past performance does not guarantee future results). Sometimes the market does worse, sometimes it does better. Sometimes it does much worse (Great Depression, anyone?) and sometimes it does much better (Post-Covid, anyone?).
“Bengen concluded that, even during untenable markets, no historical case existed in which a 4% annual withdrawal rate exhausted a retirement portfolio in fewer than 33 years.”
How do we use it?
The 4% rule is an excellent guide when planning for retirement. Consider how much money you think you will need in retirement. $80k/yr? $100k/yr? $150k/yr?
Divide your annual budget by 4% and it will tell you what the value of your portfolio needs to be the year you retire in order to sustain you ($2 million, $2.5 million, $3.75 million, respectively).
For easy mental math: for every $20k you want to withdraw a year, you’ll need $500k invested.
Assumptions
Firstly, your withdrawal rate should be based on your portfolios initial balance. When you retire, if you have a $2.5 million portfolio, 4% is $100k/yr. Each year you can withdraw $100k, even if the value of your portfolio decreases. The idea is not that your portfolio will never run out of money, but that it last long enough to sustain you while you are still alive. On the flip side, if you have an excellent year and see a 20% growth, your withdrawal rate should not increase despite your portfolio being worth more.
Bengen’s work assumed that these retirement portfolios were well balanced between stocks and bonds. Generally, the farther away from planned retirement and investor is, the higher the percentage of their portfolio is invested in stocks as they have greater growth potential. As an investor approaches retirement they will want to increase the percentage of bonds in their portfolio to hedge against potential economic downturns.
This can be done manually by reallocating assets within your own portfolio, by getting an asset manager, or by investing in target date funds that will reallocate on your behalf based on how close you are to the target date of the fund.
In recent years, Bengen as revisted this concept and suggested that 4% might be too conservative and withdrawal rates as high as 4.5-7% might be acceptable. Critics argue that with inflation continuing to rise, safe withdrawal rates should be limited to 3%. In general, most financial advisors suggest a 4% withdrawal rate based on both Bengen’s research and the Trinity Study (so-called because the professors who did the study and wrote the paper were all professors at Trinity University). The paper, if you’d like to read it, is called “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable” by Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz and was published in 1998.
Early Retirement Considerations
This has been a hot topic conversation in the FI/RE community. The research concluded that the 4% rule supported a retirement of at least 30 years, or retiring at approximately 65. What if you want to retire at 45? Does the 4% rule still work?
You would need a portfolio with the longevity to last closer to 50 years, rather than 30, so you may need to make some alterations to your retirement planning. There are a few techniques recommended for how to achieve this longevity: (1) lower the initial withdrawal rate or (2) add supplemental income.
For option (1) you can lower your withdrawal rate to 3-3.5% instead of 4%. This can be done by either increasing your portfolio value to keep your actual withdrawal amount the same (portfolio valued at $3.34 million and a withdrawal rate of 3% still gives you $100,000/yr to live on), or by lowering expenses, allowing you to keep your portfolio value the same (only withdraw $75,000 on the $2.5 million portfolio).
Option (2) actually builds on option (1). You could add supplemental income to either delay withdrawals, skip withdrawals, or reduce your withdrawal rate. This supplemental income could be something part time, like working as a barista, substitute teacher, a referee for middle school or high school sporting events, picking up seasonal work, house hacking, etc.
In general, the 4% rule is an excellent rule to use to as you plan and save for retirement as it gives you a concrete goal to aim for.