- The 4% rule is withdrawing 4% of your account balance in the first year of retirement and adjusting that amount for inflation annually.
- The rule is based on a 1994 study of historical and anticipated returns by William Bengen.
- Withdrawing more than 4% historically exposes you to a larger risk of outliving your money.
- The 4% rule is based on a portfolio comprising 50% stocks and 50% Intermediate Treasury notes, but it can work with a 75/25 mix, too.
A lifetime of savings during your working years has allowed you to stockpile a handy sum of money for retirement. Of course, the amount of money you can withdraw from those savings every year in retirement depends on your circumstances. Still, a well-worn rule of thumb is limiting withdrawals to 4% of your account balance during your first year and adjusting that amount for inflation annually.
This 4% rule stems from a 1994 study by William Bengen. In Determining Withdrawal Rates Using Historical Data, Bengen considered the impact of varying withdrawal rates to account balances over time.
How the 4% rule was created
To determine what rate of retirement withdrawals would likely allow a portfolio to last at least 30 years, Bengen studied returns from 1926 through 1992. For future years not included in that dataset, the rule assumes an annual 10.3% and 5.2% return for stocks and Treasuries, respectively. He also assumed retirement savings were split equally (50/50) between stocks and intermediate-term Treasury notes.
Bengen then tested how long retirement portfolios would last at first-year withdrawal rates ranging from 1% to 8%, adjusted for inflation annually.
Bengen concluded most retirees could expect their accounts to last at least 30 years using the 4% rule, despite Black Swan-style drawdowns caused by bear markets or runaway inflation, such as Great Depression or during the 1970s. The market conditions in the 1970s were particularly destructive to portfolios because falling stocks and skyrocketing inflation resulted in lower account balances and higher withdrawal rates. He wrote:
“An initial withdrawal of four percent…begins to show the effects of some financial events. However, these effects are comparably mild; no client enjoys less than about 35 years before his retirement money is used up.”
The potential for accounts to withstand the negative effects of sharp drops in account balances, including during periods of high inflation, is particularly intriguing, given that’s what investors are experiencing this year.
Back to Bengen:
“Assuming a minimum requirement of 30 years of portfolio longevity, a first year withdrawal of 4 percent [Figure l(b)], followed by inflation-adjusted withdrawals in subsequent years, should be safe. In no past case has it caused a portfolio to be exhausted before 33 years, and in most cases, it will lead to portfolio lives of 50 years or longer. By comparison, a 4.25-percent first-year withdrawal could exhaust a portfolio in as little as 28 years, were past conditions to repeat themselves.
Although most retirees would agree a 35-year window is sufficient, others may wish for a longer horizon, particularly if they’re concerned about leaving money to heirs or they retired young. Bengen found that a 3% initial withdrawal rate stretched accounts even longer. Specifically, he wrote, “It [a 3% withdrawal rate] shows that all clients, regardless of the year they began their retirement, were able to enjoy at least 50 years of inflation-adjusted withdrawals from their portfolios.”
The longer window associated with a 3% first-year withdrawal amount is likely most compelling to those with much larger portfolios and relatively modest living standards. A 3%-rule means smaller portfolios may not produce enough income for retirees if there aren’t other sources of income, such as Social Security or a pension.
If you begin withdrawals at 5% or more, the risk of outliving your assets long-term increases. At 5%, Bengen’s research showed people retiring in the 1960s, and early 1970s risked running out of money in about 20 years. At a 6% rate, the odds portfolios would support a 30-year retirement fell below 40%.
Is a higher stock allocation better?
Bengen focused the 4% rule primarily on a 50/50 portfolio, but he considered withdrawal rates on various allocations, including 75% stocks and 25% intermediate-term Treasuries.
The 75/25 allocation provided more opportunities for larger account balances, with slightly more risk than the 50/50 option.
“the heavier weighting…produced some fairly significant improvements. Fully 47 scenario years result in portfolio longevities of the maximum of 50 years, while only 40 scenario years attained that pinnacle in the earlier chart [he’s referring to the 50/50 portfolio]. The only penalties occur in portfolio year 1966, which is shortened by one year, from 33 to 32 years, and in 1969, which is shortened from 36 years to 34. All the other scenario years have equal or greater longevity.”
At the same time boosting stocks to 75% improved longevity, the average portfolio balance at the 20-year mark grew. In the 50/50 portfolio, the account value after 20 years was only above $2 million for those retiring in 1975 and 1976. In the 75/25 portfolio, it was above $2 million for those retiring in 19 years of the period 1926 through 1976.
This begs the question, do results get even better if you eliminate bonds?
Bengen found the risk caused by bear markets was too great if you allocate more than 75% to stocks. He said, “Stock allocations below 50 percent and above 75 percent are counterproductive.”
The Smart Play
Stocks and bonds can fall, reducing account values. Inflation can rise, eroding purchasing power, and vice versa. So, resist the temptation to extrapolate “good” or “bad” market environments too far into the future, particularly when making retirement decisions with implications that can stretch out decades.
Bengen’s data set for formulating the 4% rule covered an extended period, including good and bad times, but there’s no telling what happens in the future. The past, as they say, doesn’t guarantee the future. Nevertheless, his conclusions provide a data-backed starting point you and your financial advisor can use to help decide on a safe withdrawal rate, and that’s better than guessing.