Does the 4% Rule still work?

By Rick Welch  December 8, 2015

Planning for retirement requires us to make assumptions about our own lives and the world around us for an extended period of time. The planning process typically starts with an analysis of our expected sources of retirement income: an investment portfolio, social security, a pension plan, real estate owned, annuities and a possible inheritance. The next steps include the factoring in of our age and expected lifespan, our anticipated spending needs and an annual adjustment for inflation. The result of this work is the calculation of a safe or sustainable withdrawal rate which over a long term should enable us to outlive our savings.

For over twenty years many retirees have relied on the 4% Rule for calculating their own sustainable withdrawal rate. Here is how it works. In the first year of retirement you withdraw 4% of your portfolio. In the second and each subsequent year you withdraw the first-year dollar amount adjusted for inflation. The amount withdrawn, plus any other income sources like a pension or social security, becomes the amount to be spent in a calendar year.  Remaining assets will then grow or shrink according to asset returns for the year and your asset allocation plan. Remember, withdrawal rates are supposed to increase as we age and spend our nest eggs. Adherence to the 4% Rule implies that one would have a low risk of outliving their savings over a 30-year retirement.  The 4% Rule can also provide an idea of how much savings may be needed for your retirement. If you intend to withdraw $25,000 from your savings in the first year of your retirement, you would need to have saved $625,000 ($25,000/.04).

The 4% Rule has come under increased scrutiny recently as yields have fallen and equity returns have become more uncertain.  Early advocates of this rule benefitted from significantly higher interest rates than we currently see in the financial markets.  The Rule depends, in part, on higher interest rates to generate income and cash flows sufficient in size to minimize the amount of reduction in account principal.  Suffering a market downturn (like the recent financial crisis) early in retirement means that you had to withdraw from savings while your portfolio was incurring market losses.  This predicament is referred to as sequence-of-returns risk which if faced in the early years of retirement can have an adverse impact on your sustainable rate of withdrawal.

So, does the 4% Rule still work? Yes.  However, it was never intended to be a steadfast rule, rather it is best used as a starting point or guide for planning your early retirement account withdrawals. The bottom line is that a better strategy might be simply to adjust your retirement withdrawals to match your life and your investment performance.  This sounds straight-forward, but in practice can be challenging.  Develop a retirement plan and update it annually.  Make it a personal goal to be flexible in your spending. Adjust your spending based on market performance – spend a little less if the market is down and allow yourself to feel more comfortable spending a bit more if the market rallies.  Review your spending assumptions each year with the understanding that real lifestyle spending changes can be difficult to make. Recent studies suggest that taking a dynamic approach to spending in the early years of retirement can have a significant impact on the sustainability of your retirement portfolio.