Here’s a simple question that untold numbers of savers and investors thinking about retirement have asked: How much money can I safely take out of my retirement accounts each year so that I don’t run out of money during my lifetime?
That seemingly basic question concerning a safe withdrawal rate had no easy answer until financial planner William Bengen came up with what is now known as “the 4% rule” in 1994.
What is the 4% rule?
Writing in the Journal of Financial Planning, Bengen explained how an analysis of stock market returns and retirement scenarios over the previous 75 years led to his conclusion that if a retiree were to take 4% of a retirement portfolio’s value in the first year of retirement, and continue to take that amount (adjusted for inflation) in each subsequent year, that person would have a very remote chance of depleting his or her nest egg over the course of a 30-year retirement.
History of the 4% rule
From the outset and through to the present, there have been critics of the rule. While few quibble with Bengen’s math — he is, after all, an MIT graduate and an actual rocket scientist who later earned a master’s degree in financial planning — many critics say the rule is too simplistic. Nevertheless, its popularity spread quickly, and 4% became the drawdown percentage in countless retirement plans and an anchoring number for financial professionals and investors alike.
The rule’s assumptions
For investors on the verge of retirement or in retirement, the question is whether the 4% rule should be considered a rule of law or a rule of thumb. Most financial planning experts tend to favor the latter, largely due to Bengen’s original assumptions and guidelines.
First, the rule assumes that the retiree’s investment portfolio is split evenly between stocks and bonds. That’s probably not the way most retirement portfolios are structured, and even if investments were divided that way at the start of the calculation, asset allocation percentages usually change over time. If your portfolio doesn’t match Bengen’s assumption, says Charles Schwab, “the 4% rule won’t accurately reflect your situation.”
A second assumption of the rule is that retirees will need the same amount of income each year, adjusted for inflation. That’s unrealistic, since it doesn’t consider that an unexpected expense may arise in some years, requiring retirees to spend more than an inflation-adjusted 4%. Of course, Bengen never said a retiree had to spend all his or her 4% drawdown each year, so someone could save any unspent money for a rainy day, or a rainy year, when expenses exceed the 4% drawdown.
Impact of inflation on the 4% rule
Recognizing the criticisms and noting how market performance and inflation have changed over time, Bengen has revisited the rule. In a 2021 article for Advisor Perspectives, Bengen said a 4.7% withdrawal rate would be safe.
Then, in 2022, given the uncertainty over inflation and bond prices at the time, he told financial news website ThinkAdvisor that “if people want to take a few tenths off 4.7% and take it down to 4.5% or even 4.4%, I wouldn’t argue.
”This year, for the first time since it began analyzing safe withdrawal rates in 2021, the Chicago-based financial research and investment management firm Morningstar says that 4% is now a safe initial withdrawal rate for a diversified, 50/50 stock/bond portfolio over a 30-year time horizon. It calculated the safe rate as 3.3% in 2021 and 3.8% in 2022. The rise in interest rates, which provides greater income for many investors, and expectations of “more moderate” inflation are major reasons for the increase to 4%.
Limitations of the 4% rule
Despite its affirmation of the 4% rule, at least for this year, Morningstar cautions, “Retirement drawdown strategies remain one of the most challenging areas in all of finance.”
That’s largely because so many variables come into play when considering an individual’s withdrawal preferences and circ*mstances. Factors that vary widely in determining a safe drawdown rate include health; life expectancy (which most people tend to underestimate); whether an individual prefers steady income to variable income; how rigid or flexible someone is in their spending patterns; whether they have sources of income other than the retirement nest egg; and how much they wish to leave as bequests.
Alternatives to the 4% rule
If someone is willing to vary their spending patterns in retirement and still be sure of not running out of money for essentials, financial planner and blogger Michael Kitces suggests using a bucket approach. A retiree would divide their expenses into two buckets or categories — essential expenses (which might include rent or mortgage payments, utilities, insurance and groceries) and discretionary expenses (entertainment, travel, etc.) — and fund the fixed portion by buying an immediate annuity that would provide guaranteed income for life. Variable expenses would be funded through portfolio drawdowns that would vary with market performance.
Another variable approach to drawdowns uses required minimum distributions (RMDs). Based on actuarial life expectancy tables, RMDs draw down greater percentages of one’s retirement portfolio each year.
Using the Internal Revenue Service’s 2023 table, for example, a 72-year-old would be required to take 3.65% from her portfolio in 2023, for example, while an 80-year-old would be required to draw down 4.95%. In dollar terms, the RMD-based system produces greater retirement income when portfolios perform well and lower income when portfolios decline in value. Any income not spent in years when withdrawals are high can be saved for spending later.
Frequently asked questions (FAQs)
The rule ignores taxes. When drawdowns are made from qualified retirement accounts, including traditional individual retirement accounts and 401(k) plans, those withdrawals are considered ordinary income for tax purposes because no income tax was ever paid on the amounts invested. Withdrawals, therefore, are subject to federal income tax and any state income tax, if applicable, in the year the funds are withdrawn. Since investments in Roth IRAs are made with after-tax dollars, qualified withdrawals from Roth IRAs in retirement are tax-free.
Depending on the length of one’s retirement, the timing of the stock market’s periodic booms and slumps and the level and direction of interest rates — which determine returns in the bond market — taking more than 4% from one’s retirement portfolio could increase the chances that a retiree would run out of money sometime in their lifetime. There are no penalties for taking qualified withdrawals of more than 4% from a retirement account, but remember that taxes must be paid on all withdrawals from IRAs and qualified workplace plans, such as 401(k)s and 403(b)s.
The rule assumes a 30-year retirement. If someone were to retire at age 60, for example, the rule’s assurance about not running out of money would expire at age 90. For early retirees, therefore, the rule is less of a sure thing.
