Imagine for a moment you have just retired or become financially independent. You have spent your entire adult life saving as much as you can so that you can one-day enjoy retirement or at the very least drop out of the 40+ hour per week work grind. The years you spent saving for retirement is referred to as the accumulation period of your life. Which is just as it sounds, the period where you accumulate as much wealth as possible.
You've focused on saving money for so many years that you are likely ill-prepared for what incredibly comes after the accumulation period; the decumulation period. This is the period of your life where you stop saving money and begin to draw down on the wealth you have created over your lifetime.
Many people who are naturally good savers excel at the accumulation phase and struggle with the decumulation phase. The idea of funding your life primarily through your savings can be scary.
Anyone in this situation has the same question "how do I make sure I don't run out of money?"
That is where the 4% rule comes into play.
What is the 4% rule?
The 4% rule is a rule of thumb for the safe withdrawal rate during retirement. A safe withdrawal rate refers to how much of your retirement portfolio you can withdraw under normal market conditions, each year without running out of money.
The 4% withdrawal rate refers to how much of your retirement portfolio you liquidate in the first year of retirement. This acts as your base year.
In your second year of retirement, you can withdraw the same dollar amount you did in the first year plus inflation and from there your annual withdrawals increase by the level of inflation.
An example of the 4% rule
Let's say you just reached retirement and you have $1,000,000 saved. You've spent a lifetime accumulating that money and now you want to know how much money you can spend each year without running out of money.
According to the 4% rule, you could withdraw $40,000 in the first year of your retirement.
You'll notice that $40,000 is equal to 4% of $1,000,000.
Let's also assume that inflation is 2%.
In your second year of retirement, you could withdraw $40,800.
Your second year of retirement income is equal to what you withdrew in year 1 ($40,000) plus inflation (2% of $40,000 is $800).
You would continue funding your retirement in that fashion by increasing your withdrawal by the rate of inflation.
Action item: Use this retirement calculator to figure out how much you need to save for retirement.
Origins of the 4% rule
The origins of the 4% rule can be traced back to a 1994 paper in the Journal of Financial Planning by William Bengen. In his study, Bengen used U.S data and built a hypothetical portfolio of 50% stocks-50% bonds to find the highest sustainable withdrawal rate for a 30-year retirement. To do this he modeled the returns of this portfolio for every 30-year period from 1926 to 1992. He found that a 4% withdrawal rate was the maximum safe withdrawal rate for a 30-year retirement.
In 1998, a second study known as “the trinity study” (named after Trinity University where the study was done) found similar results as Bengen. The Trinity study found that a 4% withdrawal allowed retirees a 95% chance of not running out of money.
Limitations of the 4% rule for early retirees
It is important to note that the 4% rule was designed for a 30-year retirement. If you are planning for early retirement this could pose a problem.
It is not uncommon for people to live into their late 80's or 90's. That means if you retire in your early 50's or 40's you might be living off your retirement savings for 40 or 50 years. Since the 4% rule was only designed for a 30-year retirement, relying on the 4% rule for a longer period of time increases your odds of outliving your money.
The earlier you plan on retiring, the more conservative you should be with the 4% rule. If you plan on retiring at 50, perhaps something like a 3.5% rule makes more sense. If you plan on retiring in your 40's, perhaps a 3% rule makes sense. Use your judgment and work with a financial planner.
Sequence of returns risk
Whether you are planning for early retirement or traditional retirement, anyone using the 4% rule is exposed to sequence of returns risk.
Imagine you were about to retire in 2008. You’ve saved up your $1 million, you are all set to use the 4% rule to create $40,000 of income during retirement. Then the financial crisis hits. Your $1 million is now only worth $400,000.
If you were to retire at that time, you could only safely withdraw $16,000 in your first year of retirement. That dream of $40,000 per year in retirement went right out the window.
Sequence of returns risk is the risk that the market tanks during your first few years of retirement. If the market value of your investments drops at the same time as you begin making withdrawals from your portfolio you could run out of money during retirement.
Bottom line
The 4% rule is a useful but flawed rule of thumb to help you sort through how to live off your wealth in retirement without running out of money.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.