What is the 4% Rule?
The 4% rule refers to the amount of money you withdraw each year after retirement. It states that you should use less than 4% of the value of your portfolio, made up of stocks and bonds, in the first year after you stop working. For example, if you have $100,000 at retirement, the 4% rule would say that you can withdraw about 4% of that amount. That would be $4,000 in the first year of retirement. The percentage you withdraw remains fixed, but the amount you take will change each year with inflation. As a result, your portfolio should last for at least 30 years. The 4% rule assumes that your portfolio allocation at retirement is 50% stocks and 50% bonds.
Where Did the 4% Rule Come From?
Some sources credit Bill Bengen as the creator of the 4% rule in 1994. Whatever its origins, the 4% rule became popular after a paper titled “Retirement Savings: Choosing a Sustainable Withdrawal Rate” was published in 1998. This paper is often referred to as the “Trinity Study” because three finance professors from Trinity University authored it. The 4% rule became quoted as a “safe withdrawal rate” for use in retirement, but that’s not exactly what the Trinity Study said. Some points mentioned in the paper include:
Most retirees may benefit from having at least 50% of their portfolios in common stocks.
If you want inflation-adjusted withdrawals after retirement, you should have a withdrawal rate much lower than your initial portfolio. If your portfolio has more than 50% bonds, “for bond-dominated portfolios, withdrawal rates of 3% and 4% represent very conservative behavior.”
Updates to the Research
The authors of the Trinity Study provided updated research in the Journal of Financial Planning in 2011. The new article was titled “Success Rates for Portfolios: Where Do You Draw the Line.” Although the paper was updated, it drew the same conclusions. The new research stated:
Empirical data suggest that clients planning to make annual inflation adjustments to withdrawals should also plan for initial withdrawal rates in the range of 4% to 5% from portfolios consisting of 50% or more in large company stock to accommodate future increases in withdrawals.
Academic links focusing on retirement income commented on the 4% rule in his blog “Retirement Research.” He mentioned some of the points raised by Dr. Pfau:
The impact of taxes on the 4% rule.
The 4% rule has not worked as well in other countries as it has in the United States.
The 4% rule assumes that retirement will last for 30 years, but there is a good chance that many retirees will live longer than that after stopping work.
Risks Associated with the 4% Rule
The 4% rule can give you an idea of how much income your retirement savings can provide. For every $100,000 you have invested, you may be able to withdraw about $4,000 to $5,000 annually. This is not true in every case; if you strictly follow the 4% rule, you may face problems.
Investment Diversification
Achieving the results promised by the 4% rule depends on how you invest your savings. The 4% rule assumes that you have about 50% of your portfolio in stocks, like a diversified mix of stock index funds. This mix would mean that your return matches the overall stock market.
But
If you structure your portfolio differently, your return could be very different. You may be able to withdraw more or less.
Taxes
This rule does not take taxes into account. If you withdraw $4,000 from an IRA, you will pay federal and state taxes on that amount. Once taxes are paid, that $4,000 may give you a relatively smaller amount of money to spend.
The 4% rule can be risky if you think of it as a strict rule. When you retire, it’s better to take these “rules” as general guidelines. How you manage your money should be unique to your circumstances and personal needs.
Should You Use the 4% Rule?
The 4% rule is a good guideline to help you plan your retirement savings. However, it may not be the best system to follow once you retire. Your plan should be based on many factors, including:
All expected other sources of your income
The types of investments you have
The period you can expect to live
Your tax rate after retirement
Your needs will also change from year to year once you stop working. In some years, you may need to withdraw more due to travel or unexpected healthcare bills. In other years, you may need less.
The 4% rule becomes obsolete when you reach age 72, at which point you must start withdrawing your money from IRAs, known as “required minimum distributions,” or RMDs. These RMDs are based on a formula, which will require you to take more than 4% of your remaining account balance as you age. Each year as you age, you must withdraw a higher amount. However, you don’t have to spend the money; you essentially have to withdraw it from the IRA, which means paying taxes on it.
Does it Still Work as a Guideline?
In 2013, Michael Finke, Wade Pfau, and David Blanchett published an article titled “The 4% Rule is Unsafe in a Low-Return World.” In it, they said:
The 4% rule has worked in the United States, but it may be an exception rather than the rule. There should be more to your retirement plan than just the money you can take from your investment bag each year. When interest rates are low, withdrawing 4% may not be a smart withdrawal rate.
This research suggests that current retirees may need a different strategy. The 4% rule was based on historical data, which may no longer apply.
The 4% rule may still serve as a guideline to help you estimate how far your money will stretch after stopping work, but your overall retirement plan should be based on more than one rule.
Source: https://www.thebalancemoney.com/what-is-the-4percent-rule-in-retirement-2388273
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