Understanding the 4% Withdrawal Rule

By Jane Young, CFP, EA

A common question for investors approaching retirement is how much money is enough to retire.  The 4% withdrawal rule has become a simple rule of thumb that many use to gauge how prepared they are for retirement.  Simplicity makes this approach appealing but it may be too simple to capture all the variations and complexity in each individual situation.  

The 4% withdrawal rule was developed in 1994 by financial adviser, William Bengen.  He analyzed historical returns on stocks and bonds from 1926 through 1976 to arrive at a safe withdrawal rate.  Using an asset allocation of 50% in stock and 50% in bonds, he concluded that even during times of extreme market volatility, retirees can safely withdraw 4% of their portfolio.

This does not mean that you can withdraw 4% of your balance every year.  The rule assumes you withdraw 4% of your portfolio value in the first year of retirement, and in each subsequent year you withdraw the dollar value from the previous year plus an adjustment for inflation.  For example, if you begin retirement with $1,000,000, you can withdraw $40,000 the first year.  If the inflation rate is 3%, in the 2nd year, you can withdraw $40,000 x 1.03% or $41,200.  You can continue to take inflation adjusted withdrawals for at least 30 years.

The rule of 4% has been proven to be reliable through a wide range of tumultuous markets including the great depression, World War II, and the high inflation in the 1970s.  It can be a good place to start, to see how well positioned you are for retirement.  Prior to Bill Bengen’s research, there was no consistency on recommended withdrawal rates.   Advisers commonly recommended rates ranging from 2% to 8%.  The rule of 4% provides a solid framework to get a general idea on where you stand.

Due to the simplicity of the rule, it does not account for all the unique variables impacting each investor’s situation.  Many factors can influence the size of portfolio needed to comfortably retire including risk tolerance, tax rates, lifestyle changes, tax characteristics of your investment accounts, fees, and market performance.

The rule of 4% can be a good starting point on how you are positioned.  However, as you approach retirement it is essential to run retirement cash flow projections that incorporate variables unique to your financial situation and retirement plans.  This is a dynamic process that will change every few years based on market performance, inflation, expenses, and financial goals.  It is prudent to review retirement projections periodically, especially if circumstances and assumptions have changed.  

On-going retirement planning can give you confidence in your ability to comfortably retire and the peace of mind to spend money on things that are important to you. During a dip in the market, you may want to tighten your belt and when the market is thriving you may choose to splurge on something special.