The 4% Withdrawal Rule in Retirement: Is It a Bad Idea?
November 14, 2023
The 4% Withdrawal Rule in Retirement: Is It a Bad Idea?
November 14, 2023
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One of retirees’ greatest fears is running out of money.1,2 Some of the key questions as you prepare for retirement are, how much money will I need to retire? Will my money last through my lifetime? How much can I safely withdraw every year so that I don’t run out of money? Many financial professionals recommend that you just withdraw 4% out of your retirement accounts—including your investments, your portfolio, your bank account, whatever it happens to be—each year to avoid that reality, as long as you’ve adjusted for inflation. But can this strategy actually cause the opposite? Can the 4% rule cause you to run out of money in retirement?
How Does the 4% Rule Work?
The rule is simple: In your first year of retirement, you can withdraw 4% of the total balance of your retirement accounts. Each year thereafter, you withdraw that base of 4% and add an inflation factor on top. So, let’s say you retire with $1.5 million in your portfolio across different accounts and investment vehicles. You would withdraw 4% or $60,000 in the first year of your retirement. This $60,000 figure forms the basis for the calculation every year. Then, each year after, you would withdraw $60,000 + the inflation rate (which can be calculated in a variety of ways – see below). So, if you withdraw the initial $60,000 + 2% for inflation in year two, your withdrawal would be $61,200. You would continue to adjust for inflation each year after, essentially giving yourself a cost-of-living raise.
The 4% Rule’s History
The 4% withdrawal rule was created in the ’90s and is based on stock performance for a 50-year timeframe from 1926–1976. William Bengen, a financial advisor, conducted a comprehensive study in 1994 that evaluated the historical stock and bond returns between 1926 and 1976, especially factoring in the market downturns in the ’30s and ’70s. He modeled withdrawing 4% from your retirement accounts each year and concluded that no historical case exists where these funds were depleted in less than 33 years, despite unfavorable market conditions.
If you think back to the economy during that time, perhaps that rule made sense—especially considering bond interest rates were higher when the rule was created. But what about today? Does using a rule created over 20 years ago and based on data from 50–100 years ago still make sense for us now? Retirement researcher Wade Pfau thinks not. In his article “Say Goodbye to the 4% Rule,” he suggests that the rule is more of a theory and made too many assumptions based on old, outdated numbers that don’t translate to modern markets or investors.
The 4% rule assumes your portfolio is made up of 50–60% stocks and 40–50% bonds (this make-up varies by source); it also assumes that your spending will remain the same throughout your retirement. These assumptions don’t take into account the vast multitude of investment options you have and the diversity of retirees’ lifestyles, hobbies/interests, and goals for their retirement. It also doesn’t exactly factor in the likelihood of costly healthcare spending as you age—and healthcare costs, in general, can vary from year to year, not even accounting for emergencies, lifespans, and aging factors. It’s also important to factor in other income sources, like Social Security, a pension or annuity, and required minimum distributions. These can certainly impact how much you need to withdraw from your retirement accounts.
Downsides of the 4% Rule
This more conservative strategy works well when the markets are good—and let’s face it, they’re good right now. But the market naturally cycles with highs and lows, and there will be a drop at some point. What happens to your portfolio during market drops? You’re going to have to sell more of your stocks to pay your bills, which means when the market rises again, you’ll own fewer stocks to help your portfolio recover. The ideal situation would be to reduce your withdrawals during a market downturn to avoid running out of money down the line. Also, consider the impact of tax increases on your income and the amount you’ll need to withdraw.
Inflation can also have a significant impact on the 4% rule’s effectiveness. The rule does allow you to increase your withdrawal rate to account for inflation, but knowing how much to withdraw can be a little more complicated. You can increase your withdrawals by a flat 2% per year, the Federal Reserve’s target inflation rate—which doesn’t always mirror actual inflation rates. Or you can adjust your withdrawals according to each year’s inflation rate, a more accurate way to adjust to the cost of living.
Longevity is an important factor in the 4% rule. It was based on a 30-year retirement, either too long or too short for many. You risk running out of money if you live beyond those 30 years (and again, healthcare costs are likely to increase as you age, which means you may need to take more out of your retirement savings). On the flip side, according to the CDC, the average U.S. life expectancy as of 2020 is 77.8 years. If you retire at 65, this means you may only live 15 years into your retirement. Following the 4% rule will leave you with a financial surplus upon your death—money you could have spent on hobbies and other things you enjoy. While one retirement goal for retirees may be to leave a financial legacy to their children or other family members, managing your retirement savings and withdrawals are a balancing act to ensure you can take full advantage of your hard-earned retirement.
The 4% rule can be a good starting point and give you some peace of mind about not running out of money in retirement, but it’s not a guarantee. A popular disclaimer in the financial industry is: Past performance does not predict future results. As discussed above, this rule of thumb was created 20+ years ago based on data from 50–100 years ago, which doesn’t necessarily predict future performance based on market conditions and the overall economy. For the rule to work, retirees must strictly adhere to it every year. Significantly increasing your withdrawal—even for just one year—can have detrimental effects down the line.
While the 4% rule is simple and takes a lot of the guesswork out of retirement spending, it is not dynamic enough for most retirees. Those early in their retirement years may be more active and spend larger amounts of money as they travel and take up other hobbies. Your retirement income plan needs to account for your lifestyle and economic changes to make it easier for you to adapt your withdrawals to ensure you can maintain your desired retirement lifestyle.
The key to a successful retirement is setting up a consistent retirement income that can last the rest of your life. And this involves you taking your portfolio and breaking it into different buckets that accomplish different solutions based on your current needs. So how do you do that? You have to create your personal income strategy. Your risk tolerance and asset allocation are two significant factors that you should consider when building out what your portfolio will look like once you’re actually in retirement. One strategy that we’re using right now is developing laddering techniques with your money to make it last. If you don’t need income right now and you just want it to grow, you could set up a ladder of a three-year, a seven-year, and a 10-year bucket. With rates so low on fixed-income products, other investment products exist that pay higher rates if you can put your money in to grow without touching it.
According to Vanguard, there are five updates you can make to the 4% rule to make it work better for you.
- Estimate future returns using forward-looking predictions
- Use an appropriate time horizon – average longevity and your health are important to consider
- Minimize costs – fees and expense ratios on your investments aren’t factored into the 4% rule’s assumptions
- Invest in a diversified portfolio
- Use a dynamic spending strategy – withdraw and spend more when the markets are doing well (and providing greater returns) and withdraw and spend less when the markets in not performing well
Everyone’s retirement needs are different. The 4% rule can work for some but isn’t suitable for everybody’s situation. Financial professionals can help stress-test your portfolio and create a customized income and withdrawal plan. Then, they can help you evaluate your annual portfolio performance, spending, and other lifestyle factors and update your plan annually. Keeping your portfolio invested to some degree throughout your retirement is a key factor in avoiding running out of money—again, a financial professional can assist with allocating your portfolio to help match your needs and situation. Achieving your ideal retirement is within reach—it just may not include using the 4% withdrawal rule.
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This blog expresses the author’s views as of the date indicated, are subject to change without notice, and may not be updated. The information contained within is believed to be from reliable sources. However, its accurateness, completeness, and the opinions based thereon by the author are not guaranteed – no responsibility is assumed for omissions or errors. This blog aims to expose you to ideas and financial vehicles that may help you work towards your financial goals. No promises or guarantees are made that you will accomplish such goals. Past performance is no guarantee of future results, and any expected returns or hypothetical projections may not reflect actual future performance or outcomes. All investments involve risk and may lose money. Nothing in this document should be construed as investment, tax, financial, accounting, or legal advice. Each prospective investor must evaluate and investigate any investments considered or any investment strategies or recommendations described herein (including the risks and merits thereof), seek professional advice for their particular circumstances, and inform themselves about the tax or other consequences of any investments or services considered. Investment advisory services are offered through Liberty Wealth Management, LLC (“LWM”), DBA Liberty Group, an SEC-registered investment adviser. For additional information on LWM or its investment professionals, please visit www.adviserinfo.sec.gov or contact us directly at 411 30th Street, 2nd Floor, Oakland, CA 94609, T: 510-658-1880, F: 510-658-1886, www.libertygroupllc.com. Registration with the U.S. Securities and Exchange Commission or any state securities authority does not imply a certain level of skill or training.
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Arias, Elizabeth, Tejada-Vera, Betzaida, and Ahmad, Farida. (2021, February). Provisional Life Expectancy Estimates for January through June, 2020. CDC.gov. https://www.cdc.gov/nchs/data/vsrr/VSRR10-508.pdf
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