What You Need to Know About the “4 Percent Rule”

Am I safe? It’s a question that applies to many things in life, including retirement. Many of us want to know how much money we can spend in our golden years without depleting our nest egg.

In 1994, a financial advisor named William Bengen offered an answer to this question: the “4 percent rule.”

After analyzing historical financial data, Bengen concluded that a retiree with an investment portfolio split between stocks and bonds could “safely” withdraw 4 percent from that portfolio during the first year of retirement and follow up with inflation-adjusted withdrawals in subsequent years. In 30 years, there would still be money left over, his research showed.

The 4 percent rule has become a popular guideline for advisors and their clients as they think about retirement savings goals and withdrawal rates. But that doesn’t mean it is right for you.

“Retirement experts have clustered around a 4 percent withdrawal rate, but there’s really no one size fits all that works for everyone,” said Gerri Walsh, president of the FINRA Investor Education Foundation.

An appropriate withdrawal rate “really depends on how much you’ve put aside, how the market is performing, what your expenses are and how long you expect to live,” Walsh added.

Read on to learn more about the 4 percent rule — and other ways to think about making your retirement savings last:

How Did Bengen Come Up With His 4 Percent Formula?

Prior to Bengen’s research, many advisers looked at historic average annual market returns as a guide for how much retirees could withdraw from their accounts without depleting their savings.

But that calculation didn’t take into account “sequence of return risk,” or the risk of lower returns early in your withdrawal period. The timing of when losses occur can have a big impact on investment outcomes, so if retirees experience negative annual returns early on in retirement, they face a greater risk of exhausting their assets than if they encounter losses down the road.

Bengen, who graduated from the Massachusetts Institute of Technology with a Bachelor of Science degree in aeronautical engineering, analyzed reams of historical market and inflation data over long periods of time.

Using 1926 as a starting point, he examined every 30-year retirement period that followed. He determined that under even the worst case-scenario, a 4 percent withdrawal rate, adjusted annually for inflation, would allow a retiree’s savings to last for 30 years.

What Are Some Of The Pitfalls Of The 4 Percent Rule? 

Times change and Bengen’s original analysis may no longer apply.

“In the last few years, people have become more wary,” of the 4 percent rule, said Mike Piper, author of the blog, ObliviousInvestor.com.

With U.S. interest rates hovering near record lows, today’s retirees could experience scenarios that might be worse than the hypothetical worst case that emerged from Bengen’s research.

“The low interest rate and high stock market valuation levels facing today’s retirees are extremely rare in the U.S. historical record,” wrote Wade Pfau, a professor of retirement income at the American College of Financial Services, in a paper published last year.

Bengen, himself, has acknowledged the limits of the 4 percent rule.

“I always warned people that the 4 percent rule is not a law of nature,” he told the New York Times last year. “It is entirely possible that at some time in the future there could be a worse case.”

On the flip side, for some people, the 4 percent rule might be too conservative an approach. If your investments do well, you could end up with a lot of cash left over upon your death. While that’s money you might want to leave to your heirs, it’s also cash you could have enjoyed in retirement.

What Are Some Other Things You Can Do To Make Your Retirement Savings Last?

When you near or enter retirement, it’s important to remember that you may no longer have time to bounce back from market downturns.

As a result, you’ll want to make sure the risk profiles of your investments are appropriate given your life stage. At the same time, be aware that inflation could cut into the future buying power of your nest egg.

Take a hard look at your asset allocation. Optimally, you’ll want a mix of investments that provides the return you seek, at an appropriate level of risk. As you move through retirement and encounter life changes or economic downturns, you might want to shift your asset mix.

“When it comes to assessing how much you can withdraw from your account, discipline is key,” Walsh said. “In the early years, it’s a good idea to be conservative with your withdrawals, and resist the urge to splurge.” If the market declines, consider withdrawing less to give your investments a chance to recover.

Regardless of whether you choose to follow the 4 percent rule, or not, remember that rising expenses and declining investment returns can take a toll on how long your money will last. Keep an eye on both, and be prepared to adjust your spending accordingly.

Click here to learn more about making your retirement portfolio last.