4% Rule Definition
Planning for retirement and knowing exactly how much you need to save can be tricky. The 4% rule is a great tool to use to ensure you’re on track to meeting your retirement goals.
Where Did The 4% Rule Come From?
The 4% rule is based on a study that analyzed historical market returns to determine a realistic and sustainable withdrawal rate over a 30-year retirement period. Financial planner William Bengen popularized the rule that if you withdraw 4% of your retirement savings in the first year, and adjust future withdrawals for inflation, your portfolio should last through a 30-year retirement.
How To Calculate The 4% Rule
To calculate the 4% rule to determine how much you’ll be able to withdraw annually, you’ll first need to gather all your retirement savings to get a bulk sum of your nest egg. Once you have this number, multiply it by 0.04 and that will give you the amount you can withdraw each year before adjusting for inflation.
Let's say you have $1,000,000 saved for retirement. Take 4% of 1,000,000 and get 40,000. $40,000 is how much you can withdraw in the first year of your retirement to best ensure your 1,000,000 savings will last throughout a 30-year retirement period. In subsequent years, you’ll withdraw the previous withdrawal amount multiplied by the inflation rate of that year. So, in year two, if there is a 3% inflation rate, you’d multiply 40,000 by 1.03 and get 41,200 to withdraw for that year.
The 4% Rule During Economic Downturns
The 4% rule does not always work during economic downturns. This rule uses historical data, and the assumption that your savings are in 60% stocks and 40% bonds, to determine the rate at which you can withdraw funds. However, if there is a prolonged bear or bull market, your investment values may increase or decrease, which could deplete your savings faster than intended.
An economic downturn has an even more detrimental impact during the first few years of retirement. For example, if your savings experiences a downturn 3 years after retirement, and you’re still withdrawing at 4%, you’re taking out a higher percentage of the decreased portfolio, which could impact the compounding interest that the 4% rule relies on to work correctly.
How To Modify the 4% Rule During Economic Downturn
During economic downturns, you’ll want to consider lowering your withdrawal rate to 3% or 3.5%. It's important to stay flexible during this time knowing you may not be able to withdraw the full 4% amount. Ensure your portfolio is still diversified in order to feel less of the impacts of a volatile market.
Does The 4% Rule Work for Early Retirees?
The 4% rule plans for a 30-year retirement. If you’re planning to retire at a time where you’ll need more than 30 years of savings, the 4% rule would put you at risk of running out of your savings too early. Early retirees also have to consider that their portfolio is more vulnerable to market volatility considering a market downturn at the beginning of retirement will offset compounding interest over a longer period of time. Early retirees are also paying higher healthcare costs than those who retire at age 65 and qualify for Medicare, and these higher healthcare costs aren’t necessarily built into the 4% rule.
Is The 4% Rule Outdated?
The 4% rule is still a great starting point to determine whether you’re on track for retirement, however some experts argue that it’s an out-of-date rule and may no longer be as accurate as it once was. When the 4% rule was developed, interest rates were higher, and bonds had more substantial returns than what is offered today. This means that the steady growth of bonds may not offer as much support to a balanced portfolio as they once did. Along with interest rates, the 4% rule may not be as accurate due to more volatile markets, longer life expectancy, and higher healthcare costs. While the 4% rule was created using extensive historical data, including data from the great depression, and still in most cases, a 4% withdrawal rate sustained a portfolio over 30 years - retirees will need to use their best judgement to determine if this rule will work for their unique retirement scenario.
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This material should not be construed as a recommendation, offer to sell, or solicitation of an offer to buy a particular security or investment strategy. The information provided is for informational purposes only and should not be relied upon for accounting, legal, or tax advice. While the information is deemed reliable, Wealthspire Advisors cannot guarantee its accuracy, completeness, or suitability for any purpose, and makes no warranties with regard to the results to be obtained from its use.
