How to Use the 4% Rule for Retirement

January 25, 2023

Retirement planning can feel overwhelming. Figuring out how much money you need, how to invest it, and – crucially – how to spend it without exhausting your savings is a major challenge. That's where the 4% rule comes in. It's a surprisingly simple, yet powerful, guideline that many financial advisors recommend. Let’s break it down.

What is the 4% Rule?

Developed by financial advisor William Bengen, the 4% rule suggests that you can withdraw 4% of your initial retirement portfolio value each year and have a very high probability of the money lasting for 30 years. Essentially, you’d start with a certain amount of money, withdraw 4% of it in the first year, then adjust that amount based on investment returns. If your investments earned more than 4%, you could increase your withdrawal next year. If they earned less, you’d reduce your withdrawal to maintain the 4% target.

How Does it Work in Practice?

Let's illustrate with an example:

You retire with $1,000,000.
Year 1 Withdrawal: $40,000 (4% of$ 1,000,000)
Investment Returns: Let's assume your investments grow by 6% in Year 1.
New Portfolio Value: $1,000,000 \* 1.06 =$ 1,060,000
Year 2 Withdrawal: $42,400 (4% of$ 1,060,000)

Important Considerations & Caveats

The 4% rule isn't a guarantee, and it’s important to understand its limitations:

Inflation: The rule doesn't explicitly account for inflation. The purchasing power of $40,000 today will be much less in 30 years. You’ll likely need to adjust your withdrawals upwards to keep pace with rising prices.
Investment Returns: The rule relies on a historically average investment return of around 6-8% per year. Market volatility can significantly impact your returns, and returns are never guaranteed. More conservative investments might require higher initial withdrawals to maintain the 4% target.
Sequence of Returns: The order of investment returns really matters. If you experience a significant market downturn early in retirement, it can severely deplete your portfolio, even if subsequent returns are strong.
Longevity: People are living longer, which means you’ll need your money to last longer.
Personal Circumstances: Your spending habits and lifestyle choices will also impact your retirement savings.

Beyond the 4% Rule

While the 4% rule is a useful starting point, it's wise to consider it alongside other retirement planning strategies, such as:

Dynamic Withdrawal Strategies: These strategies adjust withdrawals based on portfolio performance and market conditions.
Spending Plans: Create a detailed budget to understand your retirement expenses.
Professional Financial Advice: Consult with a qualified financial advisor to develop a personalized retirement plan.

The Bottom Line:

The 4% rule provides a valuable framework for thinking about retirement withdrawals. However, it’s essential to understand its assumptions and limitations, and to tailor your plan to your individual circumstances. A well-rounded retirement plan that combines the 4% rule with other sound financial strategies is the best approach to achieving financial security in retirement.