The Original 4% Rule Explained
When it comes to planning for retirement income, you do not have to look very far in financial blogs and forums to find the 4% Rule and for good reason. The 4% Rule ushered in a new era of modeling techniques for financial planners to help people navigate what their retirement might look like in the future and how they can safely spend their accumulated resources over a long and uncertain timeframe.
The 4% rule was developed by financial planner William Bengen in the early 1990s. Bengen’s work, first published in 1994 in the Journal of Financial Planning, was a response to the need for a systematic approach to managing retirement withdrawals. Prior to Bengen’s research, most recommendations on how much you could spend were based on average returns of the portfolio which did not account for one of the major risks in retirement – sequence of return risk.
What Is the 4% Rule?
The 4% Rule is a guideline number in retirement that is intended to specify the maximum amount of your portfolio you can withdraw each year for a period of time without depleting your portfolio. This is known as the Safe Withdrawal Rate (SWR) or as Bill Bengen began calling it, SAFEMAX.
To calculate the safe withdrawal rate, take your beginning portfolio value at the start of your retirement and multiple that by 4% and the resulting number is how much you can spend each year.
Here are some important considerations of the 4% Rule:
- 30 Year Timeframe: The rule was developed using a 30-year timeframe.
- Inflation Adjustments: The annual spending amount is adjusted for inflation each year.
- Portfolio Allocation: The 4% Rule assumes a 50% Stock and 50% Bond Allocation with bonds being allocated to intermediate treasuries.
4% Rule Example
A 65-Year-Old retiree has a $1,000,000 retirement portfolio and is looking to determine how much can be spent for the next 30 years with a low chance of running out of money. To apply the 4% rule, the retiree would multiply $1,000,000 by 4% resulting in an annual withdrawal of $40,000 for the 1st year.
$1,000,000 x 4.0% = $40,000 Per Year Inflation Adjusted Spending
After year 1, you increase the withdrawal by the inflation that was experienced. For example, if inflation was 3.5%, you would increase your spending to $41,400. If after year 2, inflation was 2%, you would increase your spending to $42,228.
You also reduce spending if there is deflation. For example, if year 3, inflation was negative 1.5%, you would decrease your spending to $41,594.
25x Rule - the 4% rule re-arranged.
Changing around the formula results int he 25x Rule which is used to determine amount of money you should accumulate in order to spend a specfic amount of money in retirement. For example, let’s say the retiree is looking to spend $60,000 per year in retirement. To calculate the portfolio that would support this level of spending, you would multiply $60,000 by 25 resulting in a $1,500,000 portfolio.
Translating this back using te 4% rule, $1,500,000 x 4% = $60,000 per year.
How the 4% Rule was Developed
In 1994, Bill Bengen utilized actual returns of stocks and bonds up to the year 1992 to run a rolling simulation for a hypothetical retirees. Going back to 1926, he projected the retirees portfolio for each rolling 30-year period utilizing the actual returns of the portfolio and an assumed withdrawal amount from the portfolio.
At the end of the 30-Year period, he looked to see if the portfolio had a positive balance or not. If any of the retirement periods resulted in the portfolio running out, he would lower the withdrawal rate until eventually all of the rolling periods were successful.
He did run the projection for 50 years which many of the trials were successful in achieving.
From Bengen, William P. (October 1994). “Determining Withdrawal Rates Using Historical Data”
It is interesting to note that the worst periods in Bengen’s original results was not from the Great Depression. The worst rolling period in history was actually the 1966 retiree which had a poor early returns and saw massive inflation early in retirement.
Shortcomings of the 4% Rule
The 4% Rule stood out as a significant milestone in financial planning because it approached the future using more realistic assumptions about how a retiree interacts with their portfolio. However, the original research has a number of limitations when applying it to specific situations that are important to understand:
Timeframe: The 4% Rule uses 30 years as a baseline. If your timeline is greater than that, the sustainable withdrawal rate will go down. If it is shorter than that, it could be higher.
Composition of Accounts: The research ignores how your retirement assets are positioned. For example, it makes no distinction between Pre-Tax (IRA, 401k, 403b), Tax-Free (Roth IRA), and Taxable Accounts. These of course play a significant role in your ultimate ability to spend as $1,000,000 in a Pre-Tax IRA is different than $1,000,000 in a Roth IRA.
Taxes: Taxation of withdrawals and other resources are not included.
Fees: Expense ratios, product fees, and fees for an advisor are not included.
Backwards Looking vs Forward Looking: Past performance is no guarantee of future results. The research covers periods of time that will not happen again as they did in the past. Valuations, economic policy, technological advances, and geopolitical shifts can all play in to future returns being higher or lower than in the past.
Rolling Periods Overlap: The historic returns included overlapping periods skewing returns of certain years. For example, 1960 was in 30 projections whereas 1926 was only in 1.
US Focused: The returns used are focused on the United States and do not factor in the results from international markets.
Lifestyle Spending: The research assumes spending is level each year for 30 years adjusted for inflation and does not account for higher early retirement spending or lower later retirement spending.
Spending Shocks: It does not account for spending shocks like major home repairs, medical shocks, and long-term care events.
Other Income: Does not include other sources of income such as social security or pensions.
The Resulting Wave of Research
The financial planning industry didn’t stop there. The 4% Rule just started a new wave of research that now has many different branches to it to address the limitations identified above. The most common research performed subsequently reviewed the following:
- The impact of timeframe on the safe withdrawal rate.
- The impact of asset allocation on the safe withdrawal rate.
- The impact of dynamic spending rules such as increasing spending in good years and decreasing in bad.
- The impact of changing the amount of inflation adjustments.
- The impact of market valuation on withdrawal rate.
- The impact of differing capital market assumptions.
- Any many more important studies.
The Resulting Wave of Research
The 4% rule, while not without its critics and limitations, remains a foundational principle in retirement planning. It provides a simple, yet historically grounded guideline for retirees to manage their withdrawals and reduce the risk of outliving their savings. The 4% Rule provides a useful thought process on how to think about spending safely in retirement.