Is the 4 percent rule for retirement income still relevant?

Christopher M. Stock, MBA AIF®//December 7, 2022

Is the 4 percent rule for retirement income still relevant?

Christopher M. Stock, MBA AIF®//December 7, 2022

You may have heard the rule of thumb describing that it’s “safe” to withdraw a certain percentage of your investments each year in retirement. It seems like something you could plan for easily.  

While rules of thumb can be guides in decision-making, they should NOT be driving major financial decisions. When you apply a rule of thumb to your personal retirement portfolio, there are a myriad of factors that need to be taken into consideration, such as income taxes, inflation, life expectancy, stock market performance, and other income sources. A tailored plan for you canhelp you achieve your personal financial goals.  

What is the 4 percent rule? 

A commonly understood rule of thumb, created by Bill Bengen in 1994, is the four percent rule. It’s defined as a “safe” annual withdrawal rate from the funds in someone’s retirement savings accounts. This applies to an account for 30 years, with adjustments each year for inflation.  

Bengen used each 30-year period between 1926 and 1994 to analyze and create the rule. However, he only used two asset classes: large company stocks and U.S. Treasury Notes. The 1990s looked different in our economy, particularly in light of higher interest rates and inflation, and Bengen’s portfolio was only measured with a mix of half stocks and half bonds. The differences in interest rates, inflation levels, asset classes, and the balance of stocks and bonds are all very specific to how he defined the four percent rule.  

Any one of our portfolios for retirement today may reflect very different trends, current economic realities, and balances of assets.  

Potential Concerns with the 4 Percent Rule 

  • Historical market returns are used, however experts predict lower returns over the next decade.  
  • Your portfolio allocation will likely be different, and will likely change over time. 
  • Your actual spending pattern can be very different in retirement.  
  • A 30-year retirement time horizon may not be what it looks like for you.  
  • Income taxes are not accounted for, which can cause different results than expected, depending on your income sources. 
  • Investment fees are not accounted for, which can vary depending on your portfolio.  
  • This assumes a 90 percent probability of success, and some of us may be comfortable with a lower probability of success. 

Morningstar recently published a report using forward-looking estimates for investment performance and inflation. The report posited a rule of thumb should be lowered to 3.3 percent per year, assuming a balanced portfolio, fixed withdrawals over 30 years and a 90 percent probability of success (noting these are conservative estimates). Other research has also noted that in retirement, withdrawing amounts based on portfolio performance can help impact your success, meaning withdrawing less in down markets and more in good markets. This could increase the rule of thumb to closer to five percent if a flexible withdrawal rate is followed.  

Factors to Consider 

When creating a percentage withdrawal rate to follow as part of a financial plan, there are many factors to consider. What age and life expectancy will you have in retirement? How does inflation play into it? Have you considered health care costs, education for family members, or rental property income? What age will you begin drawing your Social Security benefits? What income tax rates are being assumed? What rate of return are you projecting? Are you stress-testing different rates of portfolio returns and inflation? Do you have pensions or guaranteed income annuities? What type of accounts are your assets invested in? These are just some of the factors to consider for retirement.  

A withdrawal rate can also vary over time, depending on other circumstances. Discretionary spending, which may decrease over time, can also be considered. You could also cover basic expenses from guaranteed income sources such as a pension or guaranteed income annuity, with discretionary spending from a managed investment portfolio. A mix of stocks, bonds, and cash is also important to have a diversified asset portfolio. 

The four percent safe withdrawal rule of thumb may not work for each specific situation. Taking the time to factor in these many considerations before you retire can significantly impact your retirement picture.