What Is the 4% Rule? A Quick Explanation, and Where It Falls Short

Summary:

What is the 4% Rule?

The 4% rule says you can:

• Withdraw 4% of your portfolio’s value in your first year of retirement
• Adjust that initial dollar amount for inflation every year after…
• While having a reasonably high probability of not running out of money over a 30-year period

For example, if you retire with a $1,000,000 portfolio, that’s $40,000 in year one, then $40,000 plus inflation in year two, and so on for the next 30 years and you’ll have a reasonable chance of not running out of money during that time period even with the market’s ups and downs.

Where did the 4% Rule come from?

The rule is credited to Bill Bengen based on a piece he published in the Journal of Financial Planning in 1994 where he looked at different withdrawal rates across multiple US stock and bond market return periods. His main conclusion found a 4% withdrawal was the highest “safe” number that held up in the vast majority of the tested time periods.

Here’s a reprint of the original piece.

Why is the 4% Rule so popular?

It’s simple. It’s a single number that turns the complicated question of “how much do I need to retire” into a problem that can be solved on a post-it note.

All you need to do is take your expected annual spend in retirement, divide by 4% (or multiply by 25) and you have a target portfolio size needed to support your retirement. When your portfolio reaches that number, you are theoretically ready to retire.

For example, if you anticipate spending $150,000 in your first year of retirement, the 4% rule implies you can leave the working world once your portfolio hits:

$150,000 in spend / 4% = $3,750,000 target portfolio value

You don’t need a complicated spreadsheet and you don’t have to make all kinds of assumptions about future market performance.

Five places where the 4% rule falls short

Like any single number applied generically to all situations, the 4% rule is either too conservative or not “safe” enough. Researchers since the original study argue both sides with ranges between 3-5% being safe number. Here are some of the arguments across those ranges.

The 4% rule was calculated for a 30-year retirement. The original study modeled someone retiring at a traditional age and living another 30 years. If you’re aiming to retire before 50 like many of the people we work with, your retirement could easily run 40-50 years. The study doesn’t say whether the strategy fails past 30 years, it just doesn’t go that far out.

The rule assumes a steady withdrawal amount year after year. This isn’t how people budget in retirement. People adapt. They adjust their spending down in a bad market. A rigid rule that inflation-adjusts a fixed withdrawal every year doesn’t reflect how a thoughtful retiree actually behaves. 

It’s based entirely on historical U.S. market returns. Past performance modeling has an obvious limitation. The next 30-50 years may not look like the time period in the original study. Modeled future returns dramatically impact what the safe number actually is. But nobody knows, because nobody can predict what the markets will do in the future. Even if your name rhymes with Barren Wuffett.

It doesn’t account for other income sources. A single 4% number ignores things like social security, passive real estate investments, or even part-time work throughout retirement. This can mean the rule is overly conservative if additional income sources will cover a portion of your spending needs.

It doesn’t solve for sequence of returns risk. A market downturn in your first few retirement years can significantly impact the success of your overall strategy.

For example, let’s say you need $100k a year and you retire with a $2.5m portfolio ($100k / 4%). The first month after you retire, the markets drop 50%. Your portfolio is now worth $1.25m. Your $100k withdrawal is now 8% of the portfolio. 

The 4% Rule accounts for this somewhat by design (it was tested against periods that included bad early sequences), but it’s still the single biggest reason a “safe” withdrawal rate can turn out not to be safe for a specific person’s specific timing.

How I think about the 4% Rule

I applied the 4% rule to my own finances when I left a C-level corporate career at 38. I closely monitored and managed my expenses and resigned from my job when the value of my portfolio blew past 25x my expenses. 

I have yet to find a better starting point for retirement readiness calculations than the 4% rule. But it doesn’t account for how long you’ll be retired, your mix of fixed vs. variable expenses, other income sources you have available, and what happens if the markets tank those first few years of retirement.

It’s a very blunt tool but that doesn’t mean it’s a bad starting point. The more common issues I find with people trying to retire early is that they:

• Don’t have an accurate read on what their spending needs will be once they leave corporate and they often forget to include healthcare, changes in tax situation, etc.
• Aren’t prepared for a huge market drawdown within the first few years of retirement
• Count on assets locked in 401k or IRA accounts without a plan for accessing those funds

Reach out if you’d like a second opinion on your retirement calculations

I specialize in working with people who want to or have already retired early. I’ve developed a range of strategies over the years for analyzing and then mitigating the risks associated with blindly using the 4% Rule. 

I’d be happy to to help you look over your early retirement assumptions.

If you liked this piece, you might want to check out:

• What Worked: 9 Things That Made Me Financially Independent Before 40
• The Four Money Personalities I See in High Earners
• Can You Afford to Take a Pay Cut for a Job You Love?

Nathan
Founder & Lead Advisor
[email protected]

Kangpan & Co. is a flat-fee financial advisory firm specializing in helping mid-career professionals navigate the career, family, and financial tradeoffs that come with this stage of life. This content is for educational purposes only and is not financial, legal, or tax advice. Consult a licensed advisor for help with your individual situation. Employees and clients of Kangpan & Co. may hold positions discussed in our content. Past performance is no guarantee of future results.