The 4 percent rule is a rule of thumb that tries to answer the classic question, “How much can I spend each year in retirement without running out of money?”
How long does the 4 percent rule last?
Following the 4 percent rule would allow someone to not run out of money for 30 years historically. However, there’s no guarantee following the rule today would produce the same results. The 4 percent rule is based off research conducted in the 1990s. The research concludes that based on the past, a retiree that takes 4 percent of their total investment assets at the start of their retirement, and adjusts it for inflation each year, will not run out of money for at least 30 years. This assumes an investment portfolio of 50 percent stocks and 50 percent government bonds, and that no retiree will have a retirement longer than 30 years. Many proponents of it claim that one of its biggest advantages is that it is simple to implement.
4 percent rule example
Let’s use an example. Bob and Sue have just retired with $1,000,000 in an IRA. The 4 percent rule says they can spend 4 percent of $1,000,000 in the first year of their retirement, which is $40,000. This $40,000 can be increased by inflation each year. Let’s say inflation is 3 percent each year of their retirement, and the markets give a 0 percent return for the first 5 years of their retirement. In year two, their starting portfolio value is $1,000,000 – $40,000 withdrawals = $960,000. Based on the 4 percent rule, the withdrawal would be $41,200. $40,000 starting withdrawal + 3 percent for an inflation adjustment equals $41,200.
Age | Starting Portfolio Value | Portfolio Withdrawal | Market Gain (Loss) | Inflation Rate | Ending Value |
65 | $1,000,000 | $40,000 | $0 | 3% | $960,000 |
66 | $960,000 | $41,200 | $0 | 3% | $918,800 |
67 | $918,800 | $42,436 | $0 | 3% | $876,364 |
This example illustrates how portfolio performance does not affect spending based on the 4 percent rule. Spending is only based on the starting value of your investment portfolio and the inflation afterwards. This is a significant weakness of the 4 percent rule, as it doesn’t adapt to market conditions. Blindly following the 4 percent rule could lead a retiree to spending too much of their portfolio early if the start of their retirement coincides with tough market conditions. In our example, in year 3 Bob and Sue are now almost taking a 4.6 percent withdrawal in year 3.
The 4 percent rule breaks under common retirement scenarios
One of the biggest advantages of the 4 percent rule is its supposed simplicity. The way many describe it is you retire, look at your portfolio balance, and you get 4 percent of that with inflation adjustments for the rest of your life. This sounds easy, until you try to factor in other income sources which most people have. Let’s go back to Bob and Sue, who start with $1,000,000 in an IRA. They are both retiring at age 65, and their Social Security benefits will start at age 67, so they have two years until Social Security. If Bob and Sue implement the 4 percent rule, then they will have $40,000 (+ inflation adjustments) to spend at age 65 and age 66. However, when age 67 rolls around, all of a sudden, their spending is going to increase dramatically because they will also be receiving Social Security benefits! Let’s say they have relatively modest benefits of $20,000 a year in Social Security income. In the year from age 67 to age 68, they will get $40,000 from their portfolio (+ inflation adjustments) + $20,000 of Social Security for $60,000+ of income.
Bob & Sue Age | Portfolio Withdrawal | Social Security | Total Income |
65 | $40,000 | $0 | $40,000 |
66 | $41,200 | $0 | $41,200 |
67 | $42,436 | $20,000 | $62,436 |
Most people are looking to keep their spending steady in retirement or frontload their retirement spending. Following the 4 percent rule makes this very difficult and can force followers of the rule into making poor decisions. Bob and Sue could delay their retirement two years to have their Social Security benefits begin at the same time as the 4 percent rule, but that’s a big price to pay for following the 4 percent rule! You shouldn’t have to plan your life around an arbitrary rule of thumb. They could also claim their Social Security benefits earlier at age 65, but this will cause their benefits to be smaller. If they live to a normal life expectancy in their 80’s, then this would cause them to receive less Social Security benefits during their lifetime than if they had waited to take Social Security at age 67.
So how can they retire at age 65 while still delaying Social Security and smoothing out how much income they receive over time? They need to delay beginning the 4 percent rule. The easiest method would be to look at the 4 percent rule at the start of their retirement, where they have a $1,000,000 IRA. They know they will have Social Security income of $20,000 in two years. That means they will have $60,000 in income in two years (+ inflation adjustments), so they separate their portfolio and put $120,000 off to the side. That is $60,000 of spending times two because they need two years of spending. So they will spend $60,000 for the next two years, knowing that in 2 years, their Social Security will kick in, and then they will implement the 4 percent rule then and they will get $60,000 per year. To keep it simple they give up the inflation adjustment on the $60,000 for the first two years. But wait… the math doesn’t check out!
Age | Starting Portfolio Value | Portfolio Withdrawal | Market Gain (Loss) | Inflation Rate | Ending Value |
65 | $1,000,000 | $60,000 | $0 | 3% | $940,000 |
66 | $940,000 | $60,000 | $0 | 3% | $880,000 |
67 | $880,000 | $35,200 | $0 | 3% | $844,800 |
Bob & Sue Age | Portfolio Withdrawal | Social Security | Total Income |
65 | $60,000 | $0 | $60,000 |
66 | $60,000 | $0 | $60,000 |
67 | $35,200 | $20,000 | $52,200 |
Remember that Bob and Sue decided to delay implementing the 4 percent rule until age 67 when their Social Security kicks in. When age 67 rolls around, their portfolio value is now only $880,000. Since they are delaying the 4 percent rule until age 67, they now take 4 percent of $880,000 which is only $35,200! So now they are actually spending at age 67. They could use some math to figure out that $55,555 is the amount that will equalize their income over time. However, this is a simplified scenario! We aren’t accounting for the impact of inflation OR how their portfolio changes based on what the market does. To determine the correct amount to spend, they will need to predict their portfolio value in 2 years! If it is invested in the markets, it is impossible to know what the value would be. They would need to leave their entire portfolio in cash for two years, and then invest it at age 67 to be certain they could equalize their money over their life! However, this would be breaking the 4% rule, as it only worked by keeping your portfolio invested at all times! If you want to have a relatively smooth income stream over your life, the 4 percent rule generally doesn’t allow for that.
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