Will the 4% Rule for Retirement Withdrawals Leave You Broke?

Planning for your retirement is a critical thing to do, and it involves more than just saving sufficiently (if not aggressively) and investing effectively. You also need to plan how you’ll withdraw funds over time so that you have the income stream you need without running out of money too soon.

Here’s a look at one of the most common rules of thumb for retirement withdrawals, and why you might think twice before using it.

Meet the 4% rule

Introduced by William Bengen in 1994, the 4% rule recommends withdrawing 4% of your nest egg in your first retirement year and then adjusting subsequent annual withdrawals for inflation. The table below shows what a 4% withdrawal would be for nest eggs of various sizes.

SOURCE: AUTHOR CALCULATIONS.

Imagine that you retire with $400,000 and you withdraw $16,000 in your first year — giving you about $1,333 per month. (Ideally, this income would be supplemented by Social Security benefits and perhaps some other income sources, such as a pension or an annuity.) If inflation in that first year is about 3.5% (which is close to the long-term average annual inflation rate), you’d multiply your initial $16,000 withdrawal by 1.035, getting $16,560, which would be your withdrawal in year two. If inflation rises to 6.5% in the following year, you’d multiply that $16,560 withdrawal by 1.065, getting your withdrawal for year 3: $17,636.

Got it?

The 4% rule is meant to make your money last for 30 years.

What’s the problem?

So what’s the problem? Well, there are many. For starters, the rule is based on calculations by Bengen, who assumed portfolio allocations split 50-50 or 60-40 between stocks and bonds, respectively. That’s one possible issue right there — because the average retiree’s portfolio might have a very different allocation. If you retire with, say, 70% of your portfolio in bonds and 30% in stocks, your results will likely vary a lot from Bengen’s models. Understand that a bond-heavy portfolio might grow more slowly, leading to faster depletion, while a stock-heavy portfolio might be more volatile.

The inflation rate throughout one’s retirement might also be higher, on average, than the 3% to 4% norm, which could lead one to run out of money too soon.

It’s also risky to apply the rule dogmatically. For example, what if the stock market crashes in your second year of retirement? Imagine that your nest egg was $400,000 and you took out $16,000 in year one. If that portfolio was suddenly worth only $300,000 the following year, a $16,560 withdrawal would mean you were removing far more than 4% — it would be 5.5%. If the market stayed depressed for another year, your nest egg would be further depleted ahead of schedule.

Similarly, if the market soars in an early year or two of your retirement, you could end up short-changing yourself by withdrawing less than you otherwise might.

Bengen’s models also assumed that retirees would regularly rebalance their portfolios, which is something many investors don’t do, or don’t do very often. Rebalancing involves selling and buying bonds and/or stocks as necessary in order to return to your desired allocation mix.

Finally, as life expectancies change over time, so too will the reliability of a fixed withdrawal rate.

Revisions and revisions

The 4% rule has proven popular over time, in large part due to its simplicity. It can be easily understood and applied. Clearly, though, it’s problematic — which is why many, including Bengen himself, have experimented with alternatives and suggested revised versions of it.

One of the most recent studies, titled “The Safe Withdrawal Rate: Evidence from a Broad Sample of Developed Markets,” suggested a much lower withdrawal rate — and even that is not expected 100% of the time: “A 65-year-old couple willing to bear a 5% chance of financial ruin can withdraw just 2.26% per year, a rate materially lower than conventional advice (e.g., the 4% rule).” That’s a vastly different withdrawal rate, and would get you only $9,040 in your first year of retirement if you start with a $400,000 nest egg.

What should you do?

Given that there are many different withdrawal strategies for retirement, each with various pros and cons, it’s smart to read up on at least a few and perhaps to consult one or more financial advisors as you decide how you will approach withdrawals.

Don’t use the 4% rule automatically. You might adopt a more flexible version of it — perhaps withdrawing more if the market (and your portfolio) has recently soared, and withdrawing less after a market downturn. You might be more conservative by using a 3.5% withdrawal rate, too.

It’s also well worth coming up with additional income streams, such as annuities, dividends, and perhaps even a reverse mortgage. Remember that there are steps to take to increase your Social Security benefits, too.