Today’s question comes from K:

Ks Question

Awesome question, K. And this is something all retirees need to consider.

The 4% safe withdrawal rule should be viewed more as a guideline.

Let’s first define what the 4% Safe Withdrawal Rule really is. When you read about the 4% safe withdrawal rule there are usually a few assumptions being made:

  • You still have money invested in the market at risk to get the necessary growth. Typically a 50/50 mix of stocks and bonds.
  • The time period is typically 30 years of withdrawals.
  • The probability of the portfolio not being fully depleted under the scenario is usually 90%.
  • Your first withdrawal is 4% of your account balance and each year that number is increased by inflation.

The simplicity of it is appealing and it’s easy to remember. And I do think it has a place to be used in retirement planning, as I’ll discuss later in this article.

This is how simple it is. Just start your retirement drawing out 4% of your portfolio’s value. Then each year increase the amount you draw by the inflation rate.

So if you start out with a $500,000 portfolio, your first year you would withdraw $20,000. If inflation was 3% during the next year, then you would increase your next year’s withdrawal to $20,600 ($20,000 x 1.03).

Keep doing this for the next 30 years and you should have a relatively high probability of not running out of money in retirement.

Some downsides to the 4% Safe Withdrawal Rule

There are a couple of things to keep in mind.

When the 4% safe withdrawal rule was formulated, that was in the 1990’s. Interest rates were higher then, and the markets were mostly bull markets. In today’s investing world, I view 4% as a guideline. If stuck to rigidly it could potentially lead to some bad results.

For example, let’s say you retire and calculate your 4% withdrawal amount. On a hypothetical $500,000 portfolio that would be $20,000. You start withdrawing that. But then next year the market has a big crash and your portfolio loses half its value, down to $250,000.

If you stick to the 4% rule, you will still draw out the $20,000. This is effectively 8% of your portfolio value due to the market drop. When you make withdrawals from a portfolio while it is also depressed from a market crash, this can sometimes be very difficult for the portfolio to recover. This can affect you the rest of your retirement.

The lesson is if you have poor returns in the early years of your retirement, but still rigidly stick to the 4% rule, this could be disastrous.

I discussed this “timing of returns” phenomenon once, where I took 2 hypothetical portfolios that had the same average returns over 20 years. The only difference was one portfolio had the good years’ of returns in the early years, and the other had the bad years’ of returns in the early years. Very drastic difference. 

The 4% rule was never about withdrawing just 4% of your current portfolio throughout retirement. It was stating that you take your initial portfolio level when you retire (say it’s $500,000). And draw 4% each year (that would start you at $20,000 withdrawals). Then you increase that $20,000 amount each year based on inflation. So the next year if inflation is 3% you would draw out $20,600 (that’s $20,000 x 1.03). It doesn’t matter what your portfolio value is the next year, you would draw out $20,600.

So if your portfolio had a big downturn (like 2008) and lost half its value, the 4% rule would still have you drawing out the $20,000 adjusted for inflation that year. In other words, you’d be drawing out much more than 4% of your current portfolio value.

The 4% Safe Withdrawal Rule Assumes Portfolio Depletion

Also note that the 4% safe withdrawal rule assumes that the portfolio can deplete over time. The reason the rule has the word “Safe” in it, is that based on studies of historical market performance, there is a high probability that a portfolio will not completely deplete after 30 years.

Completely depleting a portfolio is terrifying to any retiree. But making withdrawals from a portfolio as part of a well thought out plan is perfectly acceptable to fund your retired years. The 4% rule can be used as a starting point for withdrawals to help avoid complete depletion. Which brings me to my next point.

What good is the 4% Safe Withdrawal Rule

The big benefit of the 4% rule is that it can be used as a guideline for how much savings you need to afford the retirement you want. If you need $20,000 of income in retirement (on top of your Social Security and pension income), then a good savings goal to aim for is $500,000 ($500,000 x 4% = $20,000).

You may need more or less, depending on what the future holds. But it’s a good goal and starting point.

When planning for retirement you are projecting into the future. No one knows for certain what the future holds. All we can do is responsibly prepare for it.

This means we all need to be a little flexible and not stick rigidly to the 4% rule. I like to think that William Bengen (the man who came up with the 4% rule) would even admit this.

The great thing about the 4% rule is it’s easy to remember. It’s simple to apply. It is not complicated. I like that about it.

And then as the future unfolds, we can use our common sense to remain flexible and know when to modify our withdrawals. Even if that means deviating from what the 4% rule strictly prescribes.

Great question, K. I know that one is important for all retirees.

4% Safe Withdrawal Rule