The 4 Percent Rule

What is the 4 percent rule?

You’re a retiree or nearing retirement. In that case, you’ve probably heard that you’re especially vulnerable to soaring inflation since it means you’ll have to stretch your dollars further – which can be challenging when living on a fixed income.

One of the most popular rules of thumb regarding retirement spend-down strategies is the 4% rule – we wrote about it here.

4% Rule

The 4% rule suggests that retirees can safely withdraw the amount equal to 4 percent of their savings during the year they retire and then adjust for inflation each subsequent year for 30 years.

This strategy suggests that to maintain their desired living situation into retirement, they should plan to withdraw 4% of total retirement savings and assets from their investment portfolio in the first year of retirement. Then, in each subsequent year, the annual withdrawal rate from your retirement portfolio would vary based on inflation.

The 4% rule is relatively simple to follow. You can withdraw 4% of your portfolio’s value in your initial retirement year. For example, if you have total retirement savings of $500,000, you can withdraw $20,000 in the first year. Beginning the following year, you would need to factor in inflation, so for example, if inflation were 3.5%, your retirement withdrawal would be $20,000 x 1.035 (or $20,700). By calculating and including inflation, the goal is to maintain your purchasing power over time.

With increasing inflation, your portfolio will need to earn a higher return, or there’s a greater chance your portfolio will be depleted in part because consumer prices in the U.S. have hit a 40-year record high. With such a high inflation rate, many financial planners and retirement planning experts say that the 4% rule is no longer feasible for the long term and that running out of money can become a real fear – including Bill Bengen, who created the rule in the 1990s.

Before inflation took off in recent months, Bengen had gone on record about past performance to state that most new retirees could afford to have retirement portfolios that follow a 4.7% withdrawal rate.

But lately, he’s been giving interviews and warning retirees to cut back on their early-retirement withdrawals until there’s a clearer picture of whether inflation will be a short-term phenomenon or if it will stick around for the long term.

Read more: How to Prepare Your Retirement Portfolio for Inflation.

Determining how much you need in your nest egg to withdraw 4%.

Several retirement calculators are available online, but below is a simple way to quickly calculate the retirement funds needed if you decide to use the 4 percent rule for retirement.

• Take 80-100% of your pre-retirement monthly income. To be safe, most retirement experts will tell you to use 100% to account for unexpected expenses in retirement.
• Subtract any monthly income from other sources like pensions or Social Security.
• Multiple that number by 12 (months).
• Multiple that number by 25 ( if you follow the 4% rule of your total retirement savings per year).

For example, if your pre-retirement monthly income is $6,000 monthly, you receive $2,000 in Social Security and $1,000 from a pension.

Then your calculation would be ((($6,000 – ($2,000 + 1,000)) X 12) X 25))), which would be $900,000. This amount would be the amount required for your initial portfolio value to have a high probability of lasting 30 years.*

*This example is provided for illustrative purposes only and is not a projection or recommendation of any investment strategy.

What is the new rule?

There isn’t a hard-and-fast new withdrawal rate. Everyone has a different financial situation, with various withdrawal rates, initial portfolio values, and sources of income (Social Security, pensions, etc…).

According to Bengen, retirees who followed his updated 4.7% withdrawal rule might be more comfortable by cutting back slightly to 4.4%.

Meanwhile, other sources (such as Morningstar) say that 3.3% is the current suggested withdrawal rate.

Considerations when Choosing a Withdraw Strategy

When mapping out your retirement withdrawal strategy, you must consider factors that include:

Your marital status

• The two significant factors affecting your optimal retirement withdrawal strategies are marital status and state of residence. With a strategy in place to receive the total value of the joint taxable account upon a spouse’s death for a married couple in a community property state, it may be worth holding off withdrawing the funds from the tax-deferred accounts till the event of the step-up.

Your retirement savings

• A few options are the 4% retirement withdrawal rule, the fixed dollar withdrawals, and the withdrawal buckets strategy.

Your life expectancy

• One of the hardest things to determine is how long you will live. The current average life expectancy for a male is 84 years, whereas a woman is 86.6, says the Social Security Administration.

The kinds of retirement accounts you have

• You will find that there are different rules to consider for IRA withdrawals, Roth IRA withdrawals, and traditional 401 k withdrawals.

Stock and Bond returns

• Stocks tend to provide higher returns over a more extended period than bonds. Stocks tend to be more volatile than bonds and can experience large price swings in both directions. The returns from a stock investment will vary more widely than those from a bond investment. As a result, those planning for their retirement should consider the risk associated with each type of asset before committing resources to either one.
• Bond returns tend to be less volatile and often have lower maximum gains than stocks over long periods. However, they offer greater security when stock markets perform poorly, as they generally hold their value better than stocks do in such environments. Consequently, retirees might consider investing some of their retirement savings into high-quality bonds to protect against market volatility.
• Understanding the potential stock and bond returns associated with retirement withdrawals is critical for making sound financial decisions during retirement years. By including both these types of investments in their portfolio, the benefits offered are the relative safety of bonds while still benefiting from the higher return potential provided by stocks over the long term.

What do you think your living expenses will be in retirement?

• According to the Bureau of Labor Statistics, someone aged 65+ spent, on average, a little over 4k a month, coming to almost 49k a year between 2016 and 2020. Considering this number and paying attention to inflation will keep your withdrawal strategies on target.

How much do you plan to donate to charity?

• Being generous in retirement is a great way to leave a lasting legacy. Deciding early on what percentage of your income you’d like to give back can help you budget better and prevent surprises when it comes time to recommend charities.

Alternative strategies to the 4% Withdrawal

Bucket withdrawal strategy

Retirement Savings

The Bucket withdrawal strategy will have you pulling from three buckets. These will be separate accounts that will hold your assets. The three buckets will include a retirement savings account with three to five years of your living expenses, the second is a fixed income security, and the third contains the rest of your initial portfolio and your investments in equities. As you deplete the first bucket, you can replenish using the earnings from the other buckets. Allowing your savings to grow is a more hands-on approach to your retirement income and will become more time-consuming.

Fixed dollar withdrawals

A fixed dollar withdrawal plan will have a fixed amount you withdraw from retirement savings each year. Reassessment is required every few years, but you leave the same withdrawal amount set for five years.

Choosing the Right Pension Payout

If you’re lucky enough to have a defined benefit plan, you must decide how to withdraw those assets. Should you take a lump-sum payout or annuitize your pension? Each option has benefits and disadvantages. Pension withdrawal strategies can be complex, so it’s best to consult a top financial planner or advisor before making any decisions.

Retirement Income

Ultimately, the 4 percent rule can be used as a starting point to withdraw funds in retirement. However, there are many factors to consider when making this choice. To devise a plan that accounts for all possibilities, examine your financial situation, such as marital status and life expectancy, your retirement income, how much you can save, and how much money you need to cover living expenses.

Additionally, beware of factoring in current stock and bond returns over the long term—they may ebb and flow throughout your retirement years. Some people may use the 4 percent rule when withdrawing funds, while others may desire a more tailored approach. Whatever path you choose, make sure it is right for you.

While no amount of planning can guarantee that your finances will remain constant over time, having an idea of what options will work best for you is immensely beneficial. What is the best retirement withdrawal strategy for you? Click here to set up a free, no-obligation retirement plan with a fiduciary financial advisor to calculate your specific withdrawal rate.