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The 4% retirement rule, often referred to simply as the 4% rule, is a retirement withdrawal strategy that provides a framework for how much a retiree should withdraw from their retirement savings each year.
The percentage of 4% is based on the idea that retirement savings can be sustainably withdrawn at this rate over an individual’s retirement of 30 years, and this will factor in market turbulence. While the 4% rule has been a foundation of retirement withdrawal, several drawbacks have been identified, and more modern and dynamic withdrawal methods have been adopted.
Origins of the 4% rule
The 4% rule was created in 1994 by William ‘Bill’ Bengen, who found as part of a study that a 4% withdrawal rate would allow for sustained withdrawals, even during volatile market conditions.
Bengen, a financial planner, analyzed the US stock and bond market returns from 1926 to 1976 – a relatively turbulent era for the American economy. Based on this data, he concluded that a 4% withdrawal plan would be suitable for any retirement portfolio, and would last at least 33 years, which is a fair estimate for retirement length.
This rule then became a foundation for retirement withdrawal planning.
How the 4% rule works
The 4% rule works as follows. If, for example, you have $1,000,000 in a retirement portfolio, you will withdraw 4% of this every year, so the first year you will withdraw $40,000.
The rule is then adjusted for inflation, so for example, if inflation was at a comfortable 2%, then you would increase the following year’s withdrawal to be withdrawing the equivalent amount. If the following year's inflation hit 3%, you would adjust accordingly.
Assuming that your portfolio consists mainly of stocks and bonds, your withdrawal may look something like this:
- Initial withdrawal: 4% of $1,000,000, so $40,000.
- Year 2: Adding on 2% for inflation ($40,000 × 1.02) = $40,800
- Year 3: Adding on 3% for inflation ($40,800 × 1.03) = $42,024
With this method, you are withdrawing a sustainable amount from your portfolio to ensure that your spending power is maintained, but also that you aren’t draining your portfolio too quickly, as your portfolio will still be growing over time.
Is the 4% rule outdated?
The 4% retirement withdrawal rule has been a benchmark for a long time, but now, many retirement and wealth planners agree that the 4% rule is an outdated system. It should be noted that Bengen himself did not always adhere to the 4% rule, and has emphasized that it was “not a one-size-fits-all approach”.
Future market conditions, inflation rates rising (particularly in recent years) and life expectancy can significantly alter the rule’s effectiveness.
Rigidity of the 4% rule
A major drawback of the 4% withdrawal rule is that it is purely economic, and doesn’t account for the fact that every retiree is different. The 4% rule doesn't consider that you might be spending more or less, year to year, depending on your lifestyle changes. This could include moving home or traveling early in your retirement, or saving for legacy wealth planning later in your retirement.
Varying portfolio composition
The 4% rule assumes that a portfolio is 50% stocks and 50% bonds, however, this is not always the case. A retiree’s portfolio will likely differ, and the investments can also change over the actual retirement period.
If a portfolio is riskier or more conservative, then the rule will need to be adjusted, as retirees could either find their portfolio running out early or not spending as much as they could.
Problem with a 30-year timeframe
The 4% rule assumes that retirement will last 30 years, which sadly for some, might not be the case – life expectancy in the US is 77.5.
However, it should also be noted that life expectancy is on the rise, and is likely to increase across the decades, even within one’s own retirement. Retirement planning should factor in each retiree’s personal circumstances and health, and ensure that they’re using their retirement as efficiently as possible.
Based on the ‘worst case’
One of the main issues with the 4% rule is that it is based on a worst-case scenario, which means that quite often, retirees will not spend all their retirement income, and therefore not enjoy retirement in the way that they should.
In ideal market conditions, returns could theoretically be so great that even a 5% withdrawal rate would not be enough. Retirement spending is not a straight line, and the 4% rule is a guideline that should be understood, but no longer implemented. Modern retirement withdrawal plans must take into account the variability of retirement and ensure that retirees are getting the most out of their money.
Moving on from the 4% rule
Retirement planning should consider moving factors for each retiree, such as the markets and also individual spending habits. Spending can be adjusted based on whether the portfolio is performing well, and also not as well. This is where retirement guardrails come in.
What are retirement guardrails?
Retirement guardrails are an intuitive strategy that provide an alternative to the rigid 4% rule. The premise is simple – the total value of the portfolio will be monitored, and once it surpasses a predefined upper threshold, spending can be increased, conversely, if the value of the portfolio drops below a certain level, it means that spending should be reduced.
This way, it means that your spending is dynamic, and your portfolio balance can be maintained throughout market shifts and lifestyle changes.
What is the Guyton-Klinger guardrail?
In 2006, Jonathan Guyton, partnering with William Klinger, released a paper titled Decision Rules and Portfolio Management for Retirees: Is the 'Safe' Initial Withdrawal Rate Too Safe?. This approach paved the way for many retirement guardrails and served as a foundation.
This approach set out to ensure that a withdrawal rate would:
- Never require a reduction in withdrawals from any previous year
- Allow for systematic increases to offset inflation
- Maintain the portfolio for at least 40 years
The Guyton-Klinger guardrail, much like the 4% rule, has served as a foundation for many retirement planners. However, there are still issues with the Guyton-Klinger guardrail.
Despite Guyton’s optimistic assertion that “applying these Decision Rules produces a "safe" initial withdrawal rate that ranges from 5.8 percent to 6.2 percent depending on the percentage of the portfolio that is allocated to equity asset classes”, the real-life withdrawal rate after this has often shown to be low.
As analyzed by Early Retirement Now, remaining true to this withdrawal approach means “the average withdrawal values for GK under the 4/5/6% initial withdrawal rates are only 2.74%, 3.02%, and 3.22% of the initial portfolio value, respectively.”
For many, the consumption is far too conservative, and an even more dynamic approach is required.
The Money Master Guardrail™
Guardrails are an effective way to monitor spending, but as demonstrated, even traditional guardrails have their limits. Static withdrawal rates do not take into account the changing risk profile associated with each retiree.
The Money Master Guardrail approach is one that we use at Brindle & Bay to ensure that every potential outcome is covered, blending all the best aspects of the 4% rule and the Guyton-Klinger guardrail.
Under the Money Master Guardrail, we can ensure that retirees have:
- A predictable monthly income
- Additional spending opportunities identified
- Clear indicators for adjustments
At Brindle & Bay, this guardrail forms a part of our Money Master Plan™ to ensure that everything is taken into account with retirement planning.
For a full breakdown of our retirement withdrawal process, you can download our free Modern Guardrails for Retirement Income white paper.
In this white paper, we’ve explained everything you need to know about our approach, the risk assessments we take, and what you can expect from your retirement with us.
