Retirement can be an exciting time, but it also comes with a big question: how do I make sure my savings last? It’s scary enough that we don’t understand all of the machinations of how our economy works, right? Thats where the four percent rule comes in. It’s one of the most widely discussed strategies for managing retirement income, and if you’re anything like me, you want to understand how it works before making financial decisions. Today, I’ll break down this rule in simple terms, explain its benefits and limitations, and share some practical ways to use it in your own retirement planning.

What Is the 4% Rule?

The four percent rule is a guideline for withdrawing money from your retirement savings in a way that helps ensure (but not guarantee) you won’t outlive your nest egg. It was developed in the 1990s by financial planner William Bengen, who studied historical market data to find a safe withdrawal rate that retirees could use. His research suggested that if you withdraw 4% of your portfolio in the first year of retirement and adjust that amount annually for inflation, your savings could last for at least 30 years.

For example, let’s say you’ve saved $1 million for retirement. Using the four percent rule, you’d withdraw $40,000 in your first year. In the second year, if inflation was 3%, you’d increase your withdrawal to $41,200. This pattern would continue each year to help maintain your purchasing power.

Why Does the 4% Rule Work?

The rule is based on historical stock and bond market returns. Bengen tested it against worst-case scenarios, including the Great Depression, and found that in nearly all cases, a retiree following the 4% rule would not run out of money within 30 years. The assumption is that a well-balanced portfolio—typically 50-75% stocks and the rest in bonds—will generate enough returns to sustain withdrawals over time.

This approach works because stock markets, despite their ups and downs, tend to grow over long periods. Bonds provide stability, helping offset risks during market downturns. The combination of these assets creates a sustainable withdrawal strategy that has historically stood the test of time.

The Benefits of the 4% Rule

One of the biggest advantages of the four percent rule is its simplicity. You don’t need complex calculations or constant portfolio adjustments—it provides a straightforward way to estimate your retirement income. Another benefit is its built-in inflation adjustment, which helps maintain your purchasing power throughout retirement.

This rule also encourages a balanced approach to investing. Since it assumes a mix of stocks and bonds, it helps retirees avoid being too conservative with their investments, which can be a risk in itself. Keeping too much in low-return assets like cash can cause your savings to lose value over time due to inflation.

The Limitations of the 4% Rule

While the four percent rule is a useful guideline, it’s not a one-size-fits-all solution. One major limitation is that it’s based on past market performance, and there’s no guarantee the future will behave the same way. If we enter a prolonged period of low returns or high inflation, withdrawing 4% may not be sustainable.

Another factor to consider is personal spending needs. Some retirees may require more than 4% in certain years—perhaps due to medical expenses or major purchases—while others may need less. The rule also assumes a 30-year retirement, but if you retire early or live past 95, you might need a more flexible approach.

Taxes are another important consideration. If most of your savings are in tax-deferred accounts like a traditional IRA or 401(k), your withdrawals will be subject to income tax. This means you may need to withdraw more than 4% to cover taxes, depending on your tax bracket.

Adjusting the 4% Rule for Your Situation

While the four percent rule is a good starting point, it’s important to personalize it based on your own financial situation. Some retirees prefer a dynamic withdrawal strategy, adjusting withdrawals based on market performance. For example, if your portfolio drops significantly during a recession, you might reduce withdrawals to give your investments time to recover. Conversely, in strong market years, you could take out a little more.

Another alternative is using a variable withdrawal rate. Some financial experts suggest starting with a lower withdrawal rate, such as 3.5%, to provide a bigger safety cushion, especially if the market is volatile early in your retirement. Others prefer a strategy called guardrails, where withdrawals fluctuate within a set range to ensure long-term sustainability.

Diversification is also key. Having multiple income sources, such as Social Security, pensions, annuities, and part-time work, can reduce reliance on your portfolio withdrawals. If you have other guaranteed income streams, you may not need to withdraw as much from your investments.

The Bottom Line

The four percent rule is a valuable tool for planning retirement income, but it’s not a rigid formula. Think of it as a starting point rather than a strict rule. The key is to remain flexible, monitor your spending, and adjust as needed based on market conditions and personal circumstances.

A safe withdrawal rate explained in the context of your own life will depend on your savings, expenses, and financial goals. If you’re unsure, consulting a financial advisor can help tailor a strategy that works best for you. Ultimately, retirement should be about enjoying life without constantly worrying about money. By understanding and adapting the four percent rule, you can build a financial plan that provides both security and peace of mind.

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Sources

• Bengen, William P. “Determining Withdrawal Rates Using Historical Data.” Journal of Financial Planning, 1994.
• Pfau, Wade D. Retirement Research: Safe Withdrawal Rates in Today’s Market, Retirement Income Journal, 2021.
• Kitces, Michael. “The 4% Rule and Why It Still Works.” Nerd’s Eye View, Kitces.com, 2023.