The 4% Rule

What is the Four Percent Rule?

The Four Percent Rule is known as the percentage amount a retiree should withdraw from their retirement account per year. It is meant to be a benchmark that provides individuals with a steady set stream of income while allowing the invested balance to continue to grow throughout retirement.

Understanding the Four Percent Rule

The four percent rule provides a guideline for financial planners in setting a portfolio’s withdrawal rate for their clients. A key driver in determining the rate is one’s life expectancy. The longer they expect to live as retirees, the longer, they will require their portfolio to support their lifestyle. A four percent withdrawal rate is a well-tested number, even while factoring in increasing medical expenses in the final stages of life.

How the Four Percent Rule was Created

The four percent rule stems from historical data on stock and bond returns over the span of 50 years, between the periods of 1926-1976. Before the 1990s, many individuals believed that 5% was the appropriate benchmark value that retirees should’ve withdrawn each year. However, through trials and experience, many began to wonder whether 5% was too high. It led William Bengen, a financial advisor, to conduct an extensive analysis of historical returns in 1994. His research included data from severe recessions or economic downfalls between the periods of 1930-1970. After many stress tests, Bengen concluded that even during economic depressions, a 4% withdrawal would not exhaust a retirement portfolio for over 30 years.

How Inflation Affects the Four Percent Rule

In light of inflation, many retirees increase their withdrawal rate to continue to adapt to stimulated economic conditions. By doing so, individuals can effectively match their income to cost-of-living changes.

When the Four Percent Rule Becomes Ineffective

The following are scenarios of when the four percent rule is not effective for retirees:

During a severe market downturn or inflationary period. The temptation to splurge on major purchases. A retiree must remain diligent and loyal to their payouts for the four percent rule to work. Irresponsible spending can lead to many poor outcomes in the future. When the principal value decreases too quickly, the compound interest received on the balance also decreases. Thereby leaving a smaller amount to sustain a retiree’s planned lifestyle.

A Perspective on the Four Percent Rule

American financial planner Michael Kitces discovered that the four percent rule might be considered slightly conservative. He states that the rule was catered to the worst economic conditions, particularly in 1929, even faring well during the two most recent financial crises. Kitces mentions that a 4% withdrawal rate may even lead to a large sum of money left over.

Nonetheless, safety is a critical aspect for retirees, especially regarding their financial situation.