Why Retirees Should Know About The 4% Rule

You’re 100% ready for retirement. And you keep hearing about the “4% rule” and how it’s an important guideline for establishing financial stability once you’ve left the work world behind. But what is this so-called “rule”? What does it mean for your finances? And should you have been paying attention to it long before you decided to check out of your job for the very last time?

Here’s an explanation of the 4% rule, as well as some important guidelines that may help you make a decision about whether it’s a good idea to let it rule your retirement life.

How The 4% Rule Came To Be

Financial adviser Bill Bengen published a paper in 1994 suggesting that retirees should plan to withdraw 4% of their assets annually, and bank on increasing or decreasing that amount based on inflation rates. How did Bengen reach this conclusion? He reviewed decades’ worth of retirement statistics as well as stock and bond returns in an attempt to determine if the retirement portfolios he studied could last – at least theoretically – up to 50 years.

His findings revealed that, in general, retirees who withdrew no more than 4% of their assets per year could expect, within reason, that their retirement funds would last up to 30 years. For two decades, the 4% rule was regarded as a major retirement guideline for retirees looking to determine their financial withdrawal rate.

A Cornerstone Of Financial Planning

Through the years, the 4% rule gained popularity because it was straightforward, easy to understand, and easily implemented. For retirees worried about having enough money to live a long and comfortable retirement, the rule provided some welcome peace of mind.

Truth be told, however, the 4% proved unrealistically rigid for many people, especially in changing economic times. In 2021, Moshe Arye Milevsky, a finance professor at York University’s Schulich School of Business in Toronto, Canada, explained that the rule requires following the principle without fail year after year, and without taking into account factors such as health or lifestyle changes, market fluctuations, inflation, or asset reductions. The 4% retirement rule calls for individuals to unrealistically lock themselves into a strategy for 30 years that ignores the very real possibility of change. And therein lies the faulty thinking behind the rule.

Thinking Beyond Just 4%

Milevsky advocates an alternative financial strategy to the 4% rule that would respond to variables such as personal retirement goals, a retiree’s age, and whether the retirement income is based on savings or investments.

Bengen, too, has revisited the rule in the last three decades, seeking to update it to better reflect financial variables. The original 4% rule only included two asset classes: large-cap stocks and treasury bonds. With the addition of a third-class, small-cap stocks, he suggests that a 4.5% rule might be a better fit for retirees.

The Takeaway

In an interview with Barron’s in 2021, Bengen stated that he believes the original 4% rule remains valid unless we reach “a severe inflationary environment.” According to his research, retirees using the 4% rule “…are doing well…They’re successful with that withdrawal rate even though they’re in a low interest-rate environment.”

As with most financial strategies and recommendations, retirees should consult with their own financial adviser about which withdrawal strategy would best suit their short-and long-term financial goals, their lifestyle choices, and their future plans. As always, it pays to be well-informed.