How the 4% Rule Works

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The 4% rule is a rule of thumb that can help you figure out how much money you can spend each year in retirement without going broke. If you're many years away from retirement, you can also use it to figure out just how much money you'll need to retire. This article is the first of a series exploring the 4% rule, how to apply it, its limitations, and alternatives to retirement spending methodologies.

My Experience with the 4% Rule

The 4% rule hit home for me two years ago at the age of 51. I had just sold my business, an online media company that owned several finance blogs. And I retired. Yes, I'm part of the FIRE (Financial Independence, Retire Early) crowd.

At the time, I did all the calculations using the 4% rule on a very conservative basis. My wife and I had more than enough to retire. But doing it is a lot different than thinking and writing about it. After I sold the business, I was scared to spend the money. In fact, I was so scared, I took a full-time job.

I know that doesn't make a whole lot of sense. But that's what I did. Now, in fairness, I worked at Forbes and enjoyed it immensely. It was lifestyle-friendly. However much I enjoyed the work, it doesn't change the fact that I built a business, sold it, and retired at the age of 51, only to go back to work out of fear of running out of money.

Now, the good news is it forced me to take a deep dive into the 4% rule. I've read dozens of papers on the 4% rule. I have read books, and I've studied dynamic spending plans, and things called guardrails.

I've even looked at how institutional investors like the Yale endowment figure out how much money they can spend each year from the endowment without running out of money. There are a lot of parallels between how an endowment functions on the one hand, and how you and I should think about spending in retirement on the other.

What I learned from studying the 4% rule is that it's a really good rule of thumb. It still works today. Second, almost no one should follow it in retirement. I know those seem to contradict each other, but they don't, and I'll explain why as we go along in this series.

In this article, we're going to look at four things. First, we cover a high-level view of what the 4% rule is and how it works. Second, we're going to look at who created the 4% rule. Third, we'll cover how to use the 4% rule to estimate how much you need to save to retire. Finally, we're going to look at some very bizarre results that can flow from actually following the 4% rule.

So let's get started.

How the 4% Rule Works

The 4% rule is simple to apply in retirement. It takes just 3 steps.

Step 1: Add up your retirement savings

The first step in using the 4% rule is to add up all of the money you've saved for retirement. This can include both retirement accounts as well as taxable accounts you expect to use to fund expenses in retirement. For example, you would include any money in a 401k or other workplace retirement plan, any IRAs that you have, and any money in taxable investing accounts, or savings accounts, certificates of deposit, or checking accounts.

Include anything you've saved, that's going to be used to fund your retirement. Typical accounts include the following:

  • 401(k)
  • 403(b)
  • 457
  • TSP
  • IRA
  • Roth IRA
  • HSA (if used for retirement)
  • Taxable investment accounts
  • Savings accounts
  • Certificates of deposit

There are a few things you don't include. You don't include social security, annuity income or pension payments. You're only factoring in money you've saved and accumulated for retirement. If you use a tool like Personal Capital to track your investments, this step is easy.

That's step one. Let's imagine that you've saved $1 million just to use a round number to make the math a little easier.

Step 2: Multiply your retirement savings by 4%

The second step is to multiply the results from step 1 by 4%. With $1 million, 4% would be $40,000. That's the amount of money using the 4% rule that you could spend in the first year of retirement.

Step 3: Beginning in year 2 of retirement, adjust the prior year's spending by the rate of inflation

It's the second year that trips some folks up. The way you calculate all the years in retirement after year one is different. Beginning in year two, you do not use 4%. Instead, you take the amount of money you were able to spend the prior year and adjust it for inflation.

So in our hypothetical we spent $40,000 in year one of retirement. Let's assume inflation is 2%. In year two, we could spend $40,800. To calculate this number, we simply add 2% to the amount we were able to spend in the previous year. Two percent of $40,000 is $800. Added to our first year spending brings us to $40,800. The following year we'll increase $40,800 by the rate of inflation (or decrease it by the rate of deflation).

Where did the 4% Rule Come From?

The 4% rule dates back to 1994. It comes from an article published in the Journal of Financial Planning by William Bengen, a certified financial planner. He is the father of the 4% rule. The article–Determining Withdrawal Rates Using Historical Data.

Bengen's primary focus wasn't actually the 4% rule as we know it today. In fact, that term doesn't appear in his paper. What he was more concerned with was how you go about calculating how much a retiree can safely withdraw each year from retirement accounts.

At that time, a lot of advisors would use average market returns and average inflation rates to determine the initial withdrawal rate. For example, they might explain to a client that a typical portfolio consisting of 60% stocks and 40% bonds has returned about 8% over the last 100 years. At the same time, inflation has averaged about 3% a year. Based on these averages, financial advisors would tell clients that they could withdraw 5% (8% average return – 3% average inflation) the first year of retirement, and then adjust that by the average rate of inflation. 3%

Bengen's concern was that actual stock market returns and actual inflation rates might not support an initial 5% withdrawal rate. Even if the averages proved to be accurate over a 30-year retirement, really bad markets and high inflation in the early years of retirement could cause a retiree to run out of money before retirement ended.

And that's in fact exactly what Bengen's paper concluded. If you wanted to be completely safe, the most you could take in your one of retirement was 4%.

Now, we will look at the methodology behind the 4% rule and the assumptions he used in later articles. Both are extremely important to understanding how we can and cannot, and how we should and should not, apply the 4% rule.

How to use the 4% Rule for Retirement Planning

You can use the 4% rule to estimate how much you'll need to save before you can retire.

Step 1: Estimate your yearly expenses in retirement

The first step is to estimate your yearly expenses in retirement. If you are near retirement, your current budget may suffice. Just remember to make adjustments if necessary to account for the transition from work (e.g., commuting costs go down, but retirement hobby or travel expenses may go up). If you are many years from retirement, taking a percentage of your current income (say 80%) may be sufficient for a rough estimate.

Step 2: Determine amount of yearly expenses covered by retirement savings

Next, estimate how much of your yearly expenses will be covered by retirement savings. For most people, social security and perhaps a part-time job will cover some portion of expenses in retirement. You can get an estimate of your social security benefits directly from the Social Security Administration.

Others may have a pension, an annuity or both. Subtract these other sources of income from your estimated yearly expenses. What is left is what must be covered by retirement savings.

Step 3: Multiply results from step 2 by 25

Multiply the results from Step 2 by 25. Note that this is the inverse of the 4% rule. If your expenses covered by retirement savings total $40,000 a year, multiplying this number by 25 gives us $1 million. Taking 4% of $1 million brings us back to $40,000.

How the 4% Rule can Lead to Bizarre Results

Now let's underscore some of the difficulties with the 4% rule and why we need to be so careful with it.

Let's imagine two couples are thinking about retiring. They're good friends, and so the four of them go to a financial advisor together. The financial advisor explains the 4% rule–they can spend 4% of their portfolio in the first year of retirement and then adjusted for inflation every year thereafter.

One couple, we'll call them the Retired Couple, decides to retire. They have a million dollar portfolio. They take out $40,000 in the first year, which leaves them with $960,000.

The second couple, will call them the Working Couple, decide to hold off for a year. They're not going to add to their retirement portfolio, but plan to use the next year to pay off some debt before they retire. So they just leave the $1 million in their portfolio.

Now, let's imagine that over the next year the market doesn't do so well. Both portfolios fall by a total of 20%. So where do we stand after the first year?

  • Retired Couple: $1 million – $40,000 spending = $960,000 – 20% = $768,000
  • Working Couple: $1 million – $0 = $1 million – 20% = $800,000

Now let's imagine the four of them go back to the advisor to find out how much they can spend in year two.

For the Retired Couple, they don't look at their balance to determine how much they can spend in year two. Recall under the 4% rule that beginning in the second year, you simply take whatever you spent the previous year and adjust it for inflation. So if we assume a rate of inflation of 2%, the Retired Couple could spend $40,800 ($40,000 + ($40,000 * .02)).

In year two, the Working Couple who are now retiring for the first time, however, have to take whatever their balance is and multiply it by our familiar 4% number. Since they're down to $800,000, 4% is $32,000.

Now if you think these results seem a little bit odd, it's because they are. Our Retired Couple has a portfolio that's lower than the Working Couple. They're down to $768,000 compared to $800,000 for the Working Couple. Yet they can take out over $8,000 more–$40,800–compared to just $32,000 for the Working Couple. That seems like a pretty bizarre result to me.

Portfolio BalanceSpending AllowedCalculation Method
Retired Couple$768,000$40,800$40,000 + 2% inflation
Working Couple$800,000$32,000$800,000 * 4%

Now, what do we do with this? Does this mean the 4% rule is invalid? Does it mean it contradicts itself? Is it difficult to apply? Well, not exactly.

It does underscore the difference between theory and reality. And in fact, we're going to cover a lot of realistic scenarios in this article series where the 4% rule, while it's a good planning tool, and it's a good rule of thumb, may not make a lot of sense when you go to actually apply it.

The good news is, I've got a number of alternatives that I'll share with you that I think can be just as effective, but maybe a bit more practical to apply. So in the next article, we're going to look at Bengen's methodology–how he actually went about calculating what we now know is the 4% rule. Once we understand that we can begin to apply this information in a practical way to both retirement planning and retirement spending.

How the 4% Rule Works–Video

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Rob Berger is a former securities lawyer and founding editor of Forbes Money Advisor. He is the author of Retire Before Mom and Dad and the personality behind the Financial Freedom Show.

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