17 Surprising Facts You Probably Don’t Know About The Retirement Income 4% Rule

If you are nearing retirement or are already retired, chances are you’ve heard of the 4% rule for determining how much money you can withdraw from your portfolio in retirement. But what does the 4% rule really mean? I conducted an informal survey by asking a few people if they were familiar with the 4% rule and what it meant for my podcast, “Everything You Need to Know About the 4% Rule”. Generally, almost everyone had heard of the 4% rule, but there was a lot of misunderstanding and uncertainty about what it means. Most of the people said the 4% rule was the percentage of money you could withdraw from your retirement portfolio and never run out of money, but this is not what the 4% rule actually means.

I’ve written before about the importance of retirement income distribution strategies and just how challenging it is to create an income plan in retirement. After you’ve worked hard for 20, 30, or 40 years and are ready to retire, it’s important you feel confident about your retirement plan. It’s also important not to rely on a retirement rule of thumb like the 4% rule to guide your retirement without having a good understanding of what the original study found and if it applies to your own retirement plan.

One of the most common questions I hear as a retirement financial advisor is “how much money can I safely withdraw from my portfolio in retirement with little or no risk of running out of money?” This is an incredibly important question and is what the 4% rule is intended to answer, but it’s important to understand the original study and its strengths and weaknesses before you use it to calculate how much income you can draw from your retirement portfolio.

The following are ten facts about the 4% rule that you may not know, but more importantly, can help you with your own retirement planning and determine how much money you can safely withdrawal from your portfolio in retirement.

  1. The 4% rule, also called the Bengen Rule, is only 25 years old.
  2. William Bengen, a financial advisor, published his research in October of 1994 in the Journal of Financial Planning under the title, “Determining Withdrawal Rates Using Historical Data.”
  3. The 4% rule was initially calculated using a 30-year retirement time-frame. Many mistakenly think the portfolio will never run out of money, but the study only looked at a 30-year time period.
  4. One of the most frequent misconceptions about the 4% rule is how to calculate the 4%. Nearly everyone I asked (yes, even other financial advisors) thought the 4% rule meant that each year in retirement, you could withdraw 4% of the balance of your investments. For example, if you had $1 million, you could pull $40,000 from the account. If the next year the portfolio had grown to $1.1 million, then the belief was that you could then take $44,000 in that second year (4% of $1.1 million). The understanding from most people I quizzed was that each year you could take 4% of the balance of the investment accounts. In essence, you do the 4% calculation each year. However, this is not how the 4% rule is actually calculated. Instead, you only calculate 4% of the investment balance once in the first year of retirement. Whatever amount that is becomes your annual income throughout retirement (plus inflation – see #5 below). Using the example above, you could withdraw $40,000 the first year of retirement. At the start of the second year, it doesn’t matter what your investment balance is because you still withdraw $40,000 – even if your account is worth $1.1 million or $900,000.
  5. The money you are withdrawing from your investments in retirement will lose purchasing power because of inflation. The 4% rule takes into consideration that the cost of most products and services goes up over time by allowing retirees to increase their initial 4% by inflation each year. In the study, Bengen used actual inflation data to calculate inflation-adjusted withdrawal rates. Using the example above, if you calculated you could withdraw $40,000 that first year in retirement, then in the second year you would increase it by the previous year’s inflation rate. If we assume that during the first year the inflation rate was 2.7%, then the second year you could withdraw $41,080 ($40,000 initial withdrawal amount + 2.7% inflation rate).
  6. Bengen conducted historical simulations using data from Ibbotson Associates’ Stocks, Bonds, Bills and Inflation. This means the 4% rule, for better or for worse, used actual historical returns in the calculation.
  7. The 4% rule uses rolling 30-year time periods. What does this mean? The Ibbotson data Bengen used went back to January of 1926. The first rolling 30-year period was the 30 years from 1926 through 1955; the second rolling 30-year time period was from 1927 through 1956; the third from 1928 through 1957, etc.
  8. The 4% rule should really be called the 4.15% rule since that was the highest withdrawal rate Bengen calculated in the 1994 study that didn’t deplete the retirement portfolio.
  9. Bengen later termed the maximum sustainable withdrawal rate “SAFEMAX.” In his calculations, the worst time period for retirees occurred during the 30-year period starting in 1966 and ending in 1995.
  10. The original 4% rule used a retirement asset allocation of 50% stocks and 50% bonds. The S&P 500 index was used for the stock allocation and intermediate-term government bonds were used for the bond allocation. Any other asset allocation would have returned different results.
  11. A few years after Bengen published his work, a group of three researchers replicated Bengen’s study. Their research is called the Trinity Study (named for Trinity University where the authors were professors) but used long-term high-grade corporate bonds instead of intermediate-term government bonds. The result? The 4% rule didn’t work; a lower withdrawal rate was needed for the portfolio to last 30 years.
  12. The 4% rule defines success as having any size balance at the end of 30 years. A balance of $4.25 million or just $4.25 are both considered successes.
  13. Bengen calculated that the retiree would withdraw funds annually at the end of each year. Others studying the 4% rule have changed the timing of the withdrawals to the beginning of each year to reflect real life.
  14. Many of those surveyed believed the 4% rule has a 95% success rate. However, this is incorrect. Bengen was interested in determining the highest inflation-adjusted withdrawal amount over a 30-year period looking at historical data. The data showed that the highest withdrawal rate that had a balance over even the worst 30-year period was 4.15%. Therefore, the 4% had a 100% success rate.
  15. On page four of the ten-page paper, Bengen has a large headline that reads, “It is appropriate to advise the client to accept a stock allocation as close to 75 percent as possible, and in no cases less than 50 percent.” Stocks, although volatile, with retirees deeming them excessively risky, were found to create higher SAFEMAX withdrawal rates. Alternatively, low(er) stock allocations created lower withdrawal rates. For example, an all bond portfolio (what many retirees would consider safe and conservative) produced a maximum inflation-adjusted withdrawal rate of only 2.5%.
  16. The 4% rule could also be called the 4.5% rule. Bengen, in later research, included small-cap stocks in the allocation and found that including this asset class increased the safe withdrawal rate to 4.5%.
  17. Some researchers, such as one of my professors in my retirement planning Ph.D. program, Wade Pfau, have suggested the 4% rule may be too generous. Citing higher fixed income rates used in the study and much lower current interest rates on fixed income now, the 4% rule may not be a safe withdrawal rate if low interest rates persist.

The 4% rule is a good place to start when thinking about how much money you can safely withdraw from your retirement portfolio. However, you shouldn’t rely on it exclusively. The 4% rule used specific assumptions that may or may not apply to you. There are many factors to take into consideration when determining how much you can pull from your retirement accounts. A slight shift in any of these factors – such as expected investment returns, length of retirement, desire for leaving an inheritance, inflation rates, and sequence of returns among others – can make a big difference in your overall retirement income plan.

Retirement should be a time when you are free to do the things you want and can enjoy life (maybe even rage against the traditional view of retirement). Nobody wants to retire only to be stressed about their finances or worried they are going to run out of money. Create a retirement income plan that gives you confidence so you can truly enjoy spending time and money doing what you love instead of being focused on your portfolio or the vagaries of the stock market.

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