The 4% Rule (of Thumb)

Early on, when diving down the deep rabbit hole of personal finance, this term kept popping up everywhere I looked. I started asking myself, what the heck is this “4% rule?” Why is literally everyone referencing it? How accurate is this thing anyway? AND WHY ARE THERE SO MANY RULES?!?

First off, relax former self, there are no hard rules here. Just guidelines that help keep you on the right track. I intentionally call it the 4% rule of thumb for this exact reason. It’s not a precise dollar amount, more of a general parameter to think of while pursuing financial independence.

By its popularity alone, it’s worth taking a closer look. Let’s dive in!

The “4% rule,” suggests that a retiree could safely withdraw 4% of their nest egg in retirement to live off, adjust annually for inflation, and not run out of money. It’s creator, Bill Bengen (yet another noted professional in the financial space with a legendary first name), never actually called it a “rule.”

In his article, Determining Withdrawal Rates Using Historical Data published in the Journal of Financial Planning in 1994, Bengen actually referred to it as the “Safemax” withdrawal rate. This idea became insanely popular at the time and is highly debated to this very day.

The theory is that a retiree could pull 4% from their investment portfolio in the first year of retirement, then adjust for inflation on future annual withdrawals. Bengen ran this through a series of simulations at different timelines and concluded that in the worst-case scenarios the nest egg would last at minimum of 33 years. For those retiring at 60-65, this seemed like the best strategy.

Let’s say you have saved up $1.25 million invested in retirement accounts, and plan to live off this for the duration of retirement. Utilizing the 4% rule, the annual withdrawals would look like this:

• First Year Withdrawal: $50,000
• Second Year Withdrawal (adjust for 2% inflation): $51,000
• Third Year Withdrawal (adjust for 3% inflation): $52,530
• Fourth Year Withdrawal (adjust for 2% inflation): $53,580

In the rare case of deflation, the retiree would subtract that % from the previous year. The idea here is that even through the roughest financial climates, and retiring at exactly the worst time, the nest egg of $1.25 million wouldn’t officially run out before 30 years. In fact, the majority of cases saw the nest egg last over 50 years.

Bengen was on a mission to find a simple answer to one of life’s most difficult questions: “What is a safe withdrawal rate for my retirement?” He ran simulations using actual market returns for retirees each year during the time period of 1926-1976. While considered aggressive at the time, he considered each retiree to have a 50/50 allocation (50% stocks / 50% bonds).

Without getting too far into the weeds on you, Bengen found that a 3% withdrawal rate showed all portfolios lasted 50+ years, and a 6% withdrawal rate showed several portfolios exhausted in less than 20 years. 4% appeared to be the sweet spot with most portfolios lasting 50 years, and the absolute worst-case scenarios would last just over 30 years.

When looking at this 50-year period, you might think these “worst-case scenarios” would be those retiring right at the cusp, or during, the great depression of the 1930s (I know I did). Interestingly enough, it was those retiring in the early to mid 1970s that saw the quickest exhaustion of their portfolios. This is mainly due to the heavy inflationary period during 1973-1974, roughly 22% (ouch!).

While the 1930s took a hefty toll on investment returns, 1929-1931 experienced a deflationary period of almost 16%! One following Bengen’s plan would have decreased their withdrawals during this time period to reflect this and may have seen their nest egg last around 50 years before depletion. Bengen goes on to state that even when the market goes down dramatically it tends to come back up; while inflation, on the other hand, is generally here to stay.

Since this article has been published, Bengen has stated that the actual safe withdrawal rate is actually closer to 5%. A 50/50 portfolio of stocks and bonds would be considered too conservative for today’s environment. His more recent advice for retirees, on the Afford Anything Podcast with Paula Pant, actually includes a portfolio with decreased stock exposure at retirement, and a continually increasing level of stocks as the retirement progresses for increased longevity.

A recent Morningstar study showed that the actual safe withdrawal rate on a balanced portfolio is estimated around 3.3%. This article on thebalancemoney.com, suggests that 3% withdrawals might be the safer bet due to lower returns on bonds and higher inflation rates.

On the flip side, this article by Lorie Konish suggests that the 4% rule is generally too low for those looking to start retirement at the standard retirement age. This article by Klipinger dives into why the 4% rule has its blind spots, and that a retiree should adjust their annual spend with market fluctuation (instead of purely inflation) to maximize their income throughout retirement. In a discussion with Sam Dogan, the Financial Samurai, Bill Bengen himself stated that the 4% rule might be too conservative in many cases.

So, which one is it? 4% is too high or too low?

At the end of the day, it’s up to you and your risk tolerance. Studies have shown that the ability to be flexible on annual spend during retirement will have greater overall returns, but not all of us have that luxury. Here’s a few things to consider:

• The 4% Rule allows for a simple fixed income over the course of 30+ years
• It is based off “worst-case scenarios” so it might be limiting your annual spend
• One year of breaking the 4% rule (especially early on) could greatly fluctuate the longevity of the portfolio
• It doesn’t factor in the cost of management fees for those with actively managed investment accounts
• It doesn’t factor in market volatility
• It isn’t factoring in other sources of income (like social security, passive income streams, etc.)
• Your actual retirement horizon might differ (like those working past the age of 65, or those in the FIRE movement)

Fixed spending during retirement might prove to be challenging. Paula Pant and Bill Bengen discuss, in this interview, how spending during retirement typically has a “U” shaped curve. Those who are recent to retirement tend to spend on travel, vacations, and other bucket list items during their “go” years. Generally, after this is a period of “slow” years where spending decreases greatly; and then finally towards the end medical costs and other factors tend to force spending to shoot up. Understanding this, strict adherence to the 4% rule creates a conundrum for certain retirees.

Creating a simple standardized answer on a complex individualized question is going to bring out the critics, and Bengen has had his fair share of them. To give the man some credit, he has stated that the individual looking to retire should look to receive individual assessment by a financial professional and not live by this rule alone.

For those of us in the wealth accumulation phase, the 4% rule is an excellent rule of thumb to use when setting financial goals. Pundits can clash back and forth about how accurate this theory can be when actually put to use, but shooting for a retirement savings goal of 25X your estimated annual spend is a great place to start.

For those who are getting closer and closer to retirement, it might be worth having a professional take a look at your situation. I am absolutely not advocating for everyone to start getting their accounts actively managed by a financial advisor charging AUM fees. Instead consider setting up an appointment with a fee only fiduciary to see where you stand and get some advice. Should you instead choose to pay an advisor AUM fees, know what you are getting into, and factor in the cost of this to your withdrawals. For example, if the AUM is 1% you might now want to consider 3% withdrawals instead of 4%.

Side Note: I need to emphasize fee ONLY fiduciary here. Some clever “financial advisors” will use terms like “fee based” which could charge an hourly rate, along with an AUM (worst of both worlds). A fee only fiduciary should charge by the hour or project as a one-time fee for advice, investment strategies, and an overall second set of eyes on your retirement plan.

Saving 25X annual spend might be pretty intimidating to a lot of us. Also, for those looking to retire early, 25X annual spend might not be enough to last your lifetime. Take a deep breath and relax. Obviously, this level of wealth doesn’t happen overnight. There are tons of factors to consider when calculating what % of our current income should be directed towards retirement.

Here’s what my current plan is, feel free to critique or utilize how you see fit:

I’m assuming, for now at least, that at age 60 I’ll have absolutely no debt (paid off house, car, etc.). Looking at my current annual spend (using today’s costs) without debt payments, plus adding for hobbies and core pursuits I might look to do between the ages of 60-90 (club memberships, travel, golf, etc.), it’s looking like my annual spend would be roughly $40k. 25X this annual spend is $1 million. Given this, I’ll plan to max out retirement accounts (as much as I can) until my investments look to reach this number at 60 years old.

This doesn’t mean I’m maxing out my retirement options till I crest $1 million, it means I’m not done making contributions to these accounts until they are projected to be at $1 million by the age of 60. Projecting a conservative 7.5% return, investments might double every decade. This would mean $500k in these accounts by age 50, or even $250k in these accounts by age 40. (The power of compound interest is amazing, make sure you two are playing on the same team)

From there I plan to (obviously continue to get any company match) focus more of my investments towards a brokerage account. It will be less tax efficient but doesn’t have the accessibility limitations that retirement accounts do. It’s worth noting here that using today’s numbers for projected retirement spending isn’t going to factor in years (possibly decades) of inflation, market volatility, taxes and other things. I’m utilizing it as a general parameter for goal setting and will adjust as life throws curveballs my way.

I love the 4% rule (of thumb)! As a guideline that is, not as a hard and fast rule. It helps the Savvy Solo come up with a generalized savings/investing goal while still in the wealth accumulation phase of life. It’s not, however, a good excuse to stop investing during our earning years (at least in my opinion).

So much of the future is unknown; inflation, market volatility, and taxes are all going to play a big role leading up to and throughout retirement. Not to mention, all the unforeseen life changes that might happen in the years leading up to age 60!

Make no mistake, my plan above will most likely change over time. When constructing a financial plan for decades in the future, it’s important to keep it flexible enough for future changes but motivating enough to take action right now. I implore you to do the same, and hit me up if you want some ideas with goal setting!

Stay classy Solos! ✌️