How the 4 Percent Rule Works in Retirement
As you think about retirement and start planning for your income needs, you might hear about some financial rules of thumb that have circulated for years. One of them is the '4 percent rule'. While it promises to simplify your planning, the concept doesn't always work.
The 4 Percent Rule in Retirement
The 4 percent retirement rule refers to your withdrawal rate: the amount of money you might withdraw each year from the starting value of your portfolio of stock and bonds in retirement.
For example, if you have $100,000 when you retire, the 4 percent rule would say that you could withdraw about 4 percent of that amount, or $4,000, the first year of retirement.
You could then increase that amount with inflation, and have a probability of almost 95 percent that your money would last for at least 30 years, assuming your portfolio allocation was 50 percent stocks and 50 percent bonds.
The 4 percent rule started to circulate after the publication of a 1998 paper, titled Retirement Savings: Choosing a Withdrawal Rate that is Sustainable, often referred to as the Trinity Study. The paper was authored by three finance professors at Trinity University.
Although the 4 percent rule has become quoted as a “safe withdrawal rate” to use in retirement, nothing stated in the Trinity study supports this conclusion. A few of this paper’s compelling conclusions include:
- "Most retirees would likely benefit from allocating at least 50 percent to common stocks."
- "Retirees who demand CPI-adjusted withdrawals during their retirement years must accept a substantially reduced withdrawal rate from the initial portfolio."
- "For stock-dominated portfolios, withdrawal rates of 3 percent and 4 percent represent exceedingly conservative behavior. "
Updates to the Research
The authors of the Trinity Study published updated research in the Journal Of Financial Planning in 2011. You can find it at Portfolio Success Rates: Where to Draw the Line. The conclusion did not meaningfully change. It states:
“The sample data suggest that clients who plan to make annual inflation adjustments to withdrawals should also plan lower initial withdrawal rates in the 4 percent to 5 percent range, again, from portfolios of 50 percent or more large-company common stocks, in order to accommodate future increases in withdrawals.”
Wade Pfau, an academic with a specialty in retirement income, commented on this study in his Retirement Researcher Blog at Trinity Study Updates. A few of the points Wade makes are:
- “Trinity study does not incorporate mutual fund fees.”
- “The 4 percent rule has not held up nearly as well in most other developed market countries as it has in the U.S.”
- ”The Trinity study considers retirement lengths of up to 30 years. Please keep in mind that for a married couple both retiring at age 65, there is a good chance for at least one of the spouses living longer than 30 years.”
The Danger of Using Rules of Thumb
The 4 percent rule in retirement misleads people who consider it an actual rule. It's best to take these “rules” as general guidelines. If you want an idea of how much retirement income your savings can support, the 4 percent rule tells you that depending on your desire to have your retirement income keep up with inflation, you can likely withdraw about $4,000 to $5,000 per year for every $100,000 you have invested.
This assumes you follow a specific portfolio mix with about 50 percent of your portfolio in stocks such as a diversified portfolio of stock index funds so that your return at least matches that of the overall market.
Another thing to keep in mind; using this rule does not account for taxes. If you withdraw $4,000 from an IRA, you will pay federal and state taxes on that amount, so your $4,000 withdrawal may only result in $3,000 of funds available to spend.
Should You Use the Rule?
Although the 4 percent retirement rule may provide a general guideline, it's best to use more precise methods to decide how much money to withdraw each year in retirement.
As an upcoming retiree, you need your own plan based on your other expected sources of income, types of investments used, expected longevity, expected tax rate each year, and numerous other factors. When you build a smart retirement income plan, it may lead to more withdrawals in some years, and less in others.
The 4 percent rule also becomes useless once you reach age 70 ½, because you're required to take withdrawals from your IRAs and each year as you get older, you must withdraw a higher amount.
Granted, you don’t have to spend the money, but you do have to withdraw it from the IRA, which means paying taxes on the money. These required minimum distributions are specified by a formula and the formula will require you to take more than 4 percent of your remaining account value as you get older.
Does It Still Work as a Guideline?
In a 2013 paper, The 4 Percent Rule is Not Safe in a Low Yield World, authors Michael Finke, Wade Pfau, and David Blanchett state:
- “The success of the 4 percent rule in the U.S. may be a historical anomaly, and clients may wish to consider their retirement income strategies more broadly than relying solely on systematic withdrawals from a volatile portfolio.”
- “The 4 percent rule cannot be treated as a safe initial withdrawal rate in today’s low-interest rate environment.”
This paper suggests that expectations may need to be revised as prior studies were based on historical data, where bond yields and dividend yields on stocks were much higher than what investors and retirees have been receiving today.