In retirement planning there is something called “The 4% Rule”. It’s often misunderstood and misquoted. The basic idea is often stated this way: during retirement, the amount that you can safely withdrawal from you savings accounts and not run out of money is 4% a year.
The rule has become a bit controversial over the years. Researchers have poked numerous holes in it and the rule’s author has updated it to reflect new market conditions and insights. And, not everyone thinks you need to use it!
So where does that leave you? Should you only withdrawal 4% out of your retirement accounts? Let’s take a look.
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Here's What the 4% Rule Really Says
The 4% Rule is based on the idea of a “safe withdrawal rate”. This means how much can you “safely” withdrawal from a portfolio during retirement without running out of money. It was created in 1994 by William Bengen, a (now retired) financial advisor.
Here’s the problem as he saw it: you can’t calculate a safe withdrawal rate by saying, for example, stocks have averaged 7% after inflation, so you should be able to withdrawal 7% a year in the future without touching the principal or running out of money. Stocks are volatile. No one knows what returns will be. Inflation might be tame, or it might not.
So, here’s what Bengen did. Instead of making assumptions of what a portfolio return might be in the future, Bengen looked at historical sequences of returns. Using a hypothetical portfolio consisting of 50% stocks and 50% bonds, he concluded that a withdrawal rate of 4% of the initial account balance at retirement, increased by inflation each subsequent year, would survive any 30-year period of time.
Much research has been added to this since Bengen published it. Since most portfolios are more complex than two asset classes, Bengen added Small Cap Stocks to the mix of Large Cap Stocks and Bonds and recalculated. With three asset classes, the safe withdrawal rate increased from 4% to 4.5%. Later, he added international stocks, increasing the safe withdrawal rate to 4.7%!
Does the 4% Rule Apply to You?
So, now that we know the 4% Rule is really the 4.5% Rule, or 4.7% Rule, we need to consider what it means for us. Digging deeper, we see the 4% Rule is based on a number of assumptions
- Withdrawal Scheme: you set an initial withdrawal rate (3%, 4%, etc.) and it increases every year with CPI
- Initial Withdrawal Rate: when you retire, you pick the highest “safe” withdrawal rate possible
- Duration: the plan will last for 30 years and is only for one individual
- Accounts: The plan will be for only one account, a tax-deferred account.
- Legacy: The investment account may be exhausted on the last day of the 30th year (i.e., no requirement for an inheritance)
- Asset Allocation: the portfolio will be 35% large cap stocks, 20% small cap stocks, 45% intermediate term Treasury bonds
- Rebalancing: the portfolio will be rebalanced once a year
- Withdrawal frequency: Withdrawals will be made once annually, at the end of each year.
- Investments: These will be made in passive funds, which track their indexes exactly.
Already we can see how you might not want to apply the 4% Rule exactly to your situation. You may retire later with less than 30 years of retirement, have more than one account (IRA’s, Roth IRA’s, 401(k)’s, pensions). If you’re married, you may have accounts for you and your spouse. Also, the above ignores taxes and expenses/fees.
So, you see you can’t just assume a 4% Withdrawal Rate is the right rate for you. Yours can be higher or lower, depending on you situation.
What's Your Safe Withdrawal Rate?
The real question is: do you have enough to make it through retirement and not run our of money? Or, can you withdrawal what you need to live the life you want? There are a number of ways of figuring this out as part of your plan. Here are a few ways to think about it.
Straight-line Cash Flow Analysis
This kind of analysis takes your starting portfolio value when you retire, adds any retirement income like social security and subtracts annual spending. Return assumptions can be made based on your portfolio allocation and used to add hypothetical value to your portfolio. Repeat each year for your retirement years (20 years, 30 years, etc.).
This is a fairly basic analysis and has a negative of requiring assigning a return assumption to various asset classes to carry forward the math each year. But, it will give you a high-level overview of your retirement plan. Specifically, if you run out of money late in life, this is a good way to highlight that.
Monte-Carlo Analysis
The term “Monte Carlo” sounds like gambling at a casino. Here’s what it is and how it helps.
The Straight-Line Analysis above uses a return assumption applied each year to show your portfolio growing. In reality, returns on asset classes are different each year. Equities returns tend to swing alot, bonds swing but not as much. Monte Carlo analysis runs your plan 100, 500 or even 1,000 times, each time with a different return assumption based on your asset allocation. Based on that it gives you the probability that your plan will be successful.
A Monte-Carlo analysis is a powerful tool. It does require making some assumption too, mainly about historical returns of asset classes and how much each asset class returns vary. But, it provides strong information that, combined with a Straight-Line Analysis gives you a good idea of where you stand.
Safe Withdrawal Rate (i.e. 4% Rule)
One thing we can conclude from the above is that there is no one correct safe withdrawal rate. What’s important to know is whether your current withdrawal rate will allow you to live comfortably in retirement. Keeping track of your withdrawal rate and updating it consistently to match your lifestyle changes and market conditions is a helpful tool. But there’s no one right safe withdrawal rate that will consistently meet your goals. That’s why you use it along with the other techniques above and consistently update your plan.
Conclusion
After looking at it, you can see the 4% rule isn’t a “rule” like the rule of gravity. You’re withdrawal rate isn’t set in stone and doesn’t have to be exactly 4% at all. Like your personal financial plan, your ideal withdrawal rate has to be customized for your needs.