"What is the '4% Rule'? How does it work? Should I use it for my retirement?"
I've fielded questions like these since the beginning of my research more than thirty years ago. In this brief essay for all to see, I'll set down my views on the 4% Rule and how it might fit into your retirement plans.
It all began with the first article I wrote, for the Journal of Financial Planning in October of 1994, "Determining Withdrawal Rates Using Historical Data." Not a very sexy title, eh? By way of explanation, I was writing for my fellow financial advisor professionals. At the time, I had no inkling of the broad public interest that my paper would provoke.
In that article, I presented my finding that a 4.15% initial withdrawal rate from a tax-advantaged account (such as an IRA or Roth IRA) had never failed to allow the account to last for at least thirty years. My research was based on reconstructing the investment experience of retirees from 1926 to date. I didn't use "Monte Carlo" or other modeling techniques; I used historical data for investment returns and inflation.
It's important to understand how I intended the money to be withdrawn each year. The first year, I specified that an amount be withdrawn equal to 4.15% of the portfolio value at the beginning of the year. For example, if you had a portfolio worth $100,000, you'd withdraw $4,150. After that first year, you'd forget the 4.15% and simply give yourself a cost-of-living-adjustment (COLA) based on the prior year's inflation (CPI, or Consumer Price Index). In that sense, my withdrawal scheme functioned much like Social Security does today.
In that paper, I didn't mention any rule or suggest that all retirees use the 4.15% number. I viewed the paper as a preliminary effort, using some simple assumptions, with more and deeper research to follow.
Shortly after the paper was published, I began to hear of references to my "4% Rule," which surprised me. Apparently, our culture's powerful forces of simplification dropped all the digits after the decimal place and converted my "finding" into a "rule." I was initially a little uncomfortable with this, especially when criticism was directed at the "rule" (and implicitly, myself) as being too conservative!
However, over time, I've made my peace with the term "4% Rule." In fact, I've adopted it as my own (after all, it came out of my research) and found a respectable place for it in my methodology. Perhaps I took a cue from the movie title, "Dr. Strangelove, or How I Learned to Stop Worrying and Love the Bomb." Or maybe I was just tired of fighting "City Hall!"
In any event, it's important to understand that the 4.15% withdrawal rate applied only to one individual, who retired late in October of 1968. That retiree ran into a "perfect storm" of multiple stock bear markets and high inflation, which caused their account value to shrink rapidly. All other retirees in my database- and I study almost four hundred today- were able to enjoy a higher withdrawal rate. Many enjoyed a much higher rate. In fact, the average "safe" withdrawal rate to ensure thirty years of income has been slightly higher than 7% over the last one hundred years.
What use, then, is the "4% Rule"? If you're very conservative, the 4.15% withdrawal rate can provide comfort that it has never failed over the last hundred years. This period included hot wars, a cold war, recessions, a depression, periods of high inflation, and COVID-19. Could the future bring even worse? Possibly, but let's not hope so!
Don't be surprised, though, that if you use the 4% Rule, you accumulate considerable wealth as you age. You're not likely to encounter the adverse circumstances experienced by the late 1968 retiree, which caused rapid depletion of their investment portfolio. Consequently, the money you could have spent earlier in retirement will pile up and compound into a massive legacy. Perhaps you're comfortable with that outcome. If so, the "4% Rule" is made for you!
I should note that since 1994, my research has grown in breadth and sophistication, and the "4% Rule" has morphed into the "4.7% Rule." In my book, "A Richer Retirement," I mention techniques that effectively increase this to 5%. However, don't look for much further expansion from that level; we seem to be reaching the point of "diminishing returns."
And that is how the 4% Rule came to be.
Best regards,
Bill Bengen
