If you're nearing or in retirement, you should be familiar with the 4% rule.
It says that you can withdraw 4% of your retirement savings each year, adjust it for inflation annually, and your money should last you at least 30 years.
It was an idea suggested by William Bengen in 1994 and one that is often cited in literature. Bengen was a financial advisor in California and came to the 4% number analyzing historic stock market data and found hat 4% was a safe withdrawal rate. Whether you went through the Great Depression or through periods of high inflation, 4% was still safe.
It's now more than thirty years later and many have wondered – is the rule is outdated?
The investing world looks a lot different today compared to the mid-nineties. Computers were not common and I doubt many were thinking about cryptocurrencies!
Our lives are different too – people are living longer, which is putting a strain on certain programs such as Social Security. Thirty years may not be long enough for some, which can be seen as lucky or unlucky depending on your perspective.
Fortunately, William Bengen is still alive and has weighed in on this. He appeared on the Morningstar The Long View podcast and said that 4% was too conservative. Retirees could live on as much as 4.5% or even 5%. The original 4% rule is a good starting guideline but you should adjust it based on your needs and your expected longevity.
In fact, Bill Bengen did an “Ask Me Anything” on Reddit in which he answered questions from the community.
First, he says that it's actually the 4.5% rule because he modified it several years ago based on new research:
The “4% rule” is actually the “4.5% rule”- I modified it some years ago on the basis of new research. The 4.5% is the percentage you could “safely” withdraw from a tax-advantaged portfolio (like an IRA, Roth IRA, or 401(k)) the first year of retirement, with the expectation you would live for 30 years in retirement.
After the first year, you “throw away” the 4.5% rule and just increase the dollar amount of your withdrawals each year by the prior year's inflation rate. Example: $100,000 in an IRA at retirement. First year withdrawal $4,500. Inflation first year is 10%, so second-year withdrawal would be $4,950.
He also addresses a risk known as the “sequence of returns risk,” which is the risk that the market takes a huge downturn early in retirement:
I find that the state of the “economy” had little bearing on safe withdrawal rates.
Two things count: if you encounter a major bear market early in retirement, and/or if you experience high inflation during retirement. Both factors drive the safe withdrawal rate down. My research is based on data about investments and inflation going back to 1926.
I test the withdrawal rates for retirement dates beginning on the first day of each quarter, beginning with January 1, 1926. The average safe withdrawal rate for all those 200+ retirees is, believe it or not, 7%! However, if you experience a major bear market early in retirement, as in 1937 or 2000, that drops to 5.25%.
Add in heavy inflation, as occurred in the 1970's, and it takes you down to 4.5%. So far, I have not seen any indication that the 4.5% rule will be violated.
Both the 2000 and 2007 retirees, who experienced big bear markets early in retirement, appear to be doing OK with 4.5%. However, if we were to encounter a decade or more of high inflation, that might change things. In my opinion, inflation is the retiree's worst enemy.
As your “time horizon” increases beyond 30 years, as you might expect, the safe withdrawal rate decreases. For example for 35 years, I calculated 4.3%; for 40 years, 4.2%; and for 45 years, 4.1%. I have a chart listing all these in a book I wrote in 2006, but I know Reddit frowns on self-promotion, so that is the last I will have to say about that.
If you plan to live forever, 4% should do it.
After reading this, it's hard to draw any other conclusion other than 4% is the absolute lowest amount. It's the super conservative figure you use if you want the money to last forever. It's been reframed, over the years, as something more than that through no fault of Bengen.
Also, it's important to note that anyone who thinks a single number could apply to all people in all situations is making a huge mistake. Unless that number is so conservative that you cannot possibly be wrong.
Fortunately, most people realize that the 4% rule was more of a rule of thumb. If you were trying to plan for your retirement in 40+ years, you have to make many assumptions and it was useful to use the 4% rule to simplify your calculations. It was never meant to be a substitute for creating a financial plan.
If you want to properly plan for retirement, you have to start by using a retirement planning tool and not just rely on a single number.
When you retire, your nest egg might provide the bulk of your spending power but you'll likely have other sources too. You will likely collect Social Security and be one of the fortunate few who have a pension. Those will all affect how much spending power you have and your nest egg will have to pick up the slack.
But if you're planning today, know that 4% is conservative and that you could go as high as 7% – with William Bengen's blessing. But do the math!
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