The 4% Rule: Why It Doesn't Fit Every Retirement Plan

Retirement is a significant life transition that often involves shifting from a regular income stream to relying on savings and investments. The withdrawal rate is a critical component of your retirement plan. It determines how much you can take out each year without depleting your savings too quickly. And the adaptability of this rate is crucial in maintaining financial security over time.

Ever since rocket-scientist-turned-financial-planner William Bengen came up with the “4% rule” in the mid-90s, it’s been the popular standard for a safe retirement withdrawal rate. This adaptable 4 percent rule suggests that if you withdraw 4% of your portfolio the first year of retirement and then adjust that amount for inflation every year thereafter, you can count on your money to last through a 30-year retirement.

In this article, we’ll explore why the 4% rule may not be suitable for everyone and how to customize it for your individual needs.

What is the 4% rule?

Bengen based the rule on over 50 years of modern market and inflation data that went back to 1926. Over any 30-year period within the years he studied,* he found that an investor with a rebalanced 50/50 portfolio could have withdrawn the inflation-adjusted 4% and not run out of money.

Thanks to its theoretical success over varied market conditions, as well as its elegant simplicity, Bengen’s somewhat dry journal article graduated to financial planning “rule” almost immediately.

Limitations of the 4% rule

Like all broad, simplified rules, the 4% rule doesn’t always match up with real life. For one thing, it doesn’t make sense to let a withdrawal rate dictate your retirement spending. Your financial plan should serve your needs, not the other way around. This is where an adaptable retirement withdrawal strategy can come into play, to help ensure your retirement aligns with your lifestyle and goals.

And while the 4% rule can be a good starting point, your withdrawal strategy also needs to account for your personal situation, which will probably evolve over the course of retirement. For example, you might retire earlier or later than usual, or your spending may change over time if you have a health condition that progresses.

Finally, your withdrawal rate may need to change to account for shifts in market conditions and inflation as well.

Your retirement is unique

The 4% rule could work if your goal is to retire, live for exactly 30 more years, and then promptly die with $0 (or more) in the bank.

Here are a few reasons that plan might not be a perfect fit for you:

• If you have a spouse or partner, there’s a greater chance that at least one of you will outlive the 30 years.
• You might want to retire early, which could make retirement longer than the norm. Or maybe you want to keep working far past typical retirement age, which could shorten it.
• Based on personal factors, like your health and family history, you might expect to live in retirement longer or less than 30 years.
• You might not want to spend all your money—your goals could include leaving a legacy for children or charities, for example.

A shorter retirement can mean a withdrawal rate of more than 4% is appropriate. A longer one likely means less. This is why embracing an adaptable 4% rule can be the right approach.

A financial advisor can help modify your withdrawal plan to account for factors like these, tailoring your retirement withdrawal strategy to your unique circumstances.

The 4% rule tells you what’s safe to withdraw – not to spend

Your ability to safely withdraw, say, an inflation-adjusted $40,000 from a $1 million portfolio doesn’t mean it’s what you can plan to spend. Here are two reasons why they aren’t the same thing.

Taxes

Taxes don’t directly impact the 4% withdrawal rate. But it’s assumed you’ll pay any taxes due out of those withdrawals, so depending on your tax situation, 4% could support spending that’s quite a bit lower.

If your money is in a taxable account, you’ll have to use part of the money to pay any taxes due on capital gains, dividends and interest.

And if your money is in a traditional retirement account, you’ll pay ordinary income tax on the withdrawal, which is likely to be an even higher amount.

In other words, depending on where your money is located, the withdrawal rate you’ll need to support a given level of spending will be different. We encourage you to work with your tax professional to consider your account type and tax situation – as well as your actual spending needs – when deciding on an adaptable retirement withdrawal strategy.

Inflation

Inflation can also eat into your spending over time, eroding the purchasing power of your retirement savings. As prices increase, the same amount of money buys less, which means your retirement spending needs may rise over time.

So, you see that inflation affects not only the cost of goods and services but also the real value of your retirement savings. This makes it crucial to consider inflation in your retirement withdrawal strategy and include regular adjustments to help sustain your lifestyle.

As a reminder, withdrawals under the 4% rule are adjusted for inflation. But if you have a non-inflation-adjusted source of income, its ability to help support your spending will decline.

You might not notice the impact of inflation at first, but eventually your income just won’t go as far anymore. And that puts more of the burden on your withdrawals. In that situation, your withdrawal rate may have to increase.

An adaptable 4% rule withdrawal strategy allows you to adjust your retirement withdrawals in response to changing inflation rates.

Your needs change over time

Another place the 4% rule runs headlong into reality: Spending isn’t constant throughout retirement.

• Early on, it’s common to spend a lot of money doing “retirement stuff” – traveling, exploring new hobbies and catching up with friends over dinner and drinks, for example.
• Later, with a shorter bucket list and less energy, retirees often slow down and settle into the comforts of home.
• But toward the end of retirement, spending can ramp up again – this time, to pay for health care, like managing chronic conditions or assisted living.

And throughout retirement, most retirees have large one-time expenses popping up – a new car, for example, or a roof replacement.

For many people, income isn’t constant either. There’s a major shift that can happen a few years in: Social Security.

If your retirement doesn’t coincide with starting your Social Security payments (whether it’s because you retire early or you wait to collect so you can keep increasing your payment), you’ll hit a point where you could suddenly have thousands of dollars in additional monthly income.

Your planner can help you maximize that interplay between Social Security and withdrawal strategies. It can mean withdrawing a higher percentage initially but then dropping it once Social Security starts.

The 4% rule doesn’t allow for higher or lower withdrawals simply because you need more or less in a given year. But there’s no reason to deny yourself that flexibility. It’s both impractical and unnecessary.

By adopting an adaptable retirement withdrawal strategy, you can adjust your withdrawals to match your changing needs throughout each stage of retirement. This approach helps ensure that your financial plan remains responsive to your life events, giving you the confidence to enjoy your retirement years.

The relationship between market conditions and withdrawal rates

Bengen’s analysis included some pretty hairy periods for the markets. His first retirees would’ve gotten walloped by the Depression early in retirement, and even they were theoretically successful.

But we all know that past performance isn’t a guarantee of future results. And again, the rigid nature of the 4% rule just isn’t a good fit for real life when it comes to the markets.

For most people, it feels unnatural (and often uncomfortable) to ignore the markets when deciding how much to spend.

In a worst-case scenario, no retiree is just going to keep spending what the 4% rule tells them is “safe” right down to their last dollar. On the flip side, retirees who watch their wealth grow more than anticipated are probably going to want to put it to use.

Knowing when to take action in a down market can be challenging. Because you’re drawing down your accounts, your balance will decline, and each withdrawal will represent a larger percentage of your assets. That might be OK temporarily, but how will you know if and when your withdrawal rate needs to change?

Rest assured that a financial advisor can review your withdrawal plan so they can work with you if spending needs to be adjusted—that’s our job.

Embracing an adaptable 4% rule retirement withdrawal strategy allows you to modify your retirement withdrawal rate in response to market conditions. By adjusting your withdrawals during market ups and downs, you can help preserve your portfolio's longevity.

The benefit of a personalized withdrawal plan

There’s nothing “wrong” or mathematically incorrect with the 4% rule—and in fact, your ideal withdrawal rate could turn out to be very close to 4%.

But we think it’s an overly simplistic answer to a complicated question. A financial advisor can use sophisticated financial planning tools to help determine a withdrawal strategy for you, taking into consideration:

• Your retirement timeline (and your spouse’s, if you have one)
• How your spending needs will vary throughout retirement
• Your specific retirement goals
• Your other sources of retirement income
• What types of accounts you’re withdrawing from

Some years, you’ll want or need to spend more or less than usual, and that’s fine! You can partner with an advisor throughout retirement to adjust your plan. That collaboration helps alleviate concerns about whether your spending is on track or derailing your retirement.

By adopting an adaptable retirement withdrawal strategy, you can ensure that your financial plan remains flexible and responsive to your unique circumstances and changing needs. At Edelman Financial Engines, we’re dedicated to helping you navigate the complexities of retirement planning, ensuring that your withdrawal strategy can help support your goals and provide peace of mind throughout your golden years.

Plan your retirement with confidence

The 4% rule isn’t “dead” – it’s still a good starting point. But all the factors that make your retirement unique also impact the ideal withdrawal strategy for you. And things like market conditions and inflation will matter, too.

If you're preparing for retirement or already enjoying your next chapter of life, it's essential to have a financial plan that adapts to your changing needs and circumstances. Contact Edelman Financial Engines today to schedule a free consultation. Let us help you create a retirement withdrawal strategy that's as unique as you are.

*Some 30-year periods necessarily included future years. For those periods, Bengen used average stock and bond returns rather than actual returns. For example, the analysis for an investor who started withdrawals in 1976 used real market data through 1992 and averages for 1993 forward.