The 4% rule for retirement planning is a helpful exercise for determining the value of a withdrawal from a portfolio at retirement. Allowing for increases to that withdrawal due to inflation and based on historical gains, the portfolio is unlikely to run out.
What is the 4% rule?
The 4% rule is a rule of thumb is used to show or work out how much money a retiree can withdraw from their retirement portfolio each year without depleting the total. Use by financial planners and retirees looks to provide a steady income from a portfolio while maintaining a positive balance throughout retirement.
Where did it originate?
William Bengen worked out his analysis in 1994 using the returns of any 30 years between 1926 and 1976 (in the US). He demonstrated that the pot of money did not run out when a withdrawal of 4% per year was taken from a 50/50 portfolio of stocks (or equities) and bonds. Instead, he showed that it depleted the portfolio over approximately 33 years.
Bengen focused heavily on the periods of severe market downturns during the 1930s and 1970s and concluded that there were no historical examples where a 4% withdrawal would cause the portfolio to run out even in these situations.
Choosing 4% for the first withdrawal and adjusting each year is known as a safe withdrawal rate (SWR) for the portfolio. SWR is a method that makes use of certain assumptions, including spending needs, a historic rate of inflation, and how much of a return the portfolio will return annually.
How can I use the 4% rule?
The 4% rule assumes that you withdraw the same amount from your portfolio every year, adjusted for inflation.
So, for example, and to keep the numbers simple, let’s say your portfolio totals £1,000,000. For your first year of retirement, you can withdraw £40,000.00. If the cost of living rises 2% that year, then the following year, you would add an additional 2% of the withdrawal amount, or £800. So in year two, you would withdraw £40,800 and so on.
Over time this reduces the value of the portfolio as the withdrawals eventually exceed the investment growth. However, there is still a positive balance in the portfolio, as shown in the chart below, after 30 years.
You can use the inverse of 4%, or 25x, to determine how much you might need to save for retirement to maintain your standard of living.
For example, if you anticipate spending £25,000 a year, using the inverse of the 4% rule, you would multiply this number by 25 to give £625,000. Over 30 years, there would still be a positive balance if you withdrew £25,000 each year adjusted for inflation.
What else should I know?
- It’s based on historical returns from the US market. Most current projections anticipate that returns are like to be below historical averages.
- It applies to a specific portfolio composition of 50/50 split between stocks and bonds. It’s possible to use alternative proportions or splits between 50/50 and still be able to withdraw 4%.
As we age, evidence shows that this type of portfolio, and the proportion of equities to bonds, is unlikely to be kept the same during retirement as we become more risk-averse. - It’s a rigid rule that doesn’t allow for changes in circumstances. For example, any changes in the total value withdrawn by the retiree above 4% will deplete the portfolio faster.
- It doesn’t consider other sources of income. The 4% rule only applies to the portfolio on its own, any additional income such as a state pension, Defined Benefit, social security or other investments that provide dividends are not taken into account.
- It assumes a 30-year time horizon which depending on when you wish to access the portfolio, may be too long or too short.
- It assumes that you wish to deplete your principle. Research has shown that retirees starting their decumulation (withdrawal) phase don’t like to see their pots go down anymore than when they were in their accumulation (building) phase.
- It is based on a very high level of confidence (close to 100%) based on historical averages. Modern retirement planning assumes that retirees can, and perhaps be flexible with their withdrawals to accommodate under or over the performance of their portfolios.
A modern interpretation of the 4% rule
The 4% rule provides a great starting point – as a rule of thumb – for how much to save for retirement.
Using the inverse (25x), you can determine how big your portfolio might need to be in the first year to meet the value of what you hope to be able to spend.
