Is the 4% Rule Really a Safe Withdrawal Rate?

Planning for retirement and trying to figure out how much money you will need can feel overwhelming. But what if there was a simple rule that helped you determine how much you needed to save now to retire later comfortably? Sounds pretty good, doesn’t it. Well, the 4% rule may be the simple rule you’re seeking. Or it may not.

What Is the 4% Rule

The 4% rule is a rule of thumb used to determine how much a retiree can safely withdraw from their retirement portfolio every year without fear of running out of money. Four percent is often known as a safe withdrawal rate (SWR).

The withdrawals usually consist of interest and dividends in good years and possibly portfolio principal in not-so-good market return years. Inflation also plays a role.

Because inflation affects the specific amount, the actual withdrawal amount may be different year to year. The funds you withdraw this year may be slightly lower than the funds you pull out next year. But that will also fluctuate based on the size of your portfolio.

Essentially the 4% rule is simple and used to determine a retirement portfolio’s withdrawal plan.

How the Math Works

The math behind the 4% rule works based on a retirement portfolio of 50% S&P500 stocks and 50% bonds. Because the market has a historical 10-year average return of 10%, not including inflation, withdrawing 4% every year (adjusted for inflation), you should not run out of money. Well, at least not with an average of 10% investment returns over a 30-year time frame.

The power of compound interest enables your retirement portfolio to keep growing over time. Any funds you don’t withdraw can increase (or decrease) based on the market. The more money you have in your portfolio (your account balance), the more the amount can go up (or down).

A simple example would be if you had someone who has annual spending of $40,000. To calculate how much the retiree would need to retire with to live off the 4% rule, you would take $40,000 and multiply it by 25. So that person would need $1 million in retirement savings before retirement.

The Impact of Inflation

Inflation can erode the spending power of your money. But the 4% rule takes this into account and adjusts the annual withdrawal amount (not rate) based on inflation.

When calculating the impact of inflation, you can either use 2% a year consistently (the national average or target rate), or recalculate the amount every year using the previous year’s actual rate (consumer price index – CPI).

Going back to our simple example, in the first year, our retiree would withdraw $40,000. But in the next year, they could remove a little more, $40,800 ($40,000 x 2% inflation). And so forth every future year.

Origins of the 4% Rule

The 4% rule comes from an article written in 1994 by William Bengen and the infamous Trinity Study published in 1998 by three professors from Trinity University in Texas.

Before this time, the safe withdrawal rate used was 5%. Meaning retirees could withdraw 5% of their portfolio every year without fear of running out of money.

Both William Bengen and the Trinity Study looked at historical stock and bond returns from 1926-1976. They analyzed rolling ten year periods and determined what the success rate of each safe withdrawal rate was.

The Trinity Study determined that throughout the time frame studied (which included the Great Depression), a 4% withdrawal rate had a 95% success rate. Meaning 95% of the time, retirees would not run out of money.

It’s important to note that historical market returns from the United States form the basis of the 4% rule. And there is some debate on what type of bonds to include in 50% of the portfolio. Bengen and the Trinity Study included different types of bonds and therefore concluded slightly different results. But the difference is negligible enough not to impact this current commentary of the rule.

Considerations and Assumptions

The 4% rule also has some considerations or caveats to be pondered before deciding to 100% commit to it in retirement.

First, the rule only works if the retirees are diligent and stick with it every year. There can be no increased withdrawal one year because it could throw the whole system off. The rule does not allow for any changes in drawdown rates due to changes in circumstances. This is a significant limitation because what retiree can predict the future that accurately?

As one ages, it may be likely that retirees will require more funds to pay for medical or living costs later in retirement. The 4% rule does not account for this change in spending needs.

Second, if the market sees a downturn at the beginning of the withdrawal time frame that doesn’t recover quickly, retirees may be subject to a sequence of return risk, which means that they may have a greater chance of running out of money in retirement. A cash or savings buffer can help to prevent this. But where is that included in the simple 4% rule of 50% stocks and 50% bonds?

Third, the foundation for the rule is a specific portfolio composition that includes 50% US equities. You may or may not be comfortable being that invested in our American neighbours. To come up with the rule, its creators also studied historical market returns. Yet, every investing platform will tell you that past performance is no indication of future returns.

Next, a safe withdrawal rate of 4% works for a 30-year retirement. If yours is longer or shorter, you risk running out of money or having a substantial amount left upon your death.

And finally, the simple rule does not account for additional income sources in retirement and their timing, for example, CPP and OAS, and at what age you begin to draw on them.

These can have a significant impact on the amount of money you will need in retirement. And the dollar amount you withdraw from your investment portfolio could impact what you are eligible to receive from CPP or OAS.

Is the 4% Rule Obsolete?

There is some debate on whether the 4% rule is now obsolete or not. I would argue that it is a simple rule of thumb and, like any simple rule, probably doesn’t apply to everyone in every situation. But it can be an excellent place to start.

Limitations of the Rule

The rule’s rigidity does not give retirees flexibility to adapt to their circumstances or optimize their withdrawals for tax or government program considerations.

According to Michel Kitces, Head of Strategy at Buckingham Wealth Partners, barring a prolonged market downturn that does not recover for years, following the 4% rule could mean dying with a large balance in your portfolio.

You may have the desire to leave an inheritance when you pass away. But I highly doubt you worked your whole life only to be restricted in retirement by a simple rule of thumb that resulted in a large chunk of your money going unspent after all.

People are also living longer now than they did between 1926-1976. And we are in a lower interest rate environment. It is uncertain if the 4% rule will hold up over time with longer life expectancies and lower interest rates. Or what relevance it will have for retirees over the next 20-40 years.

There is also a risk that with prolonged low interest rates, there could eventually be increased inflation rates (or even hyperinflation). This could kill the 4% rule as it’s adjusted for inflation. The high inflation adjustments could rapidly liquidate a retiree’s portfolio.

Canadian Considerations

This simple rule may not be relevant for retired Canadians who have to convert their RRSP to an RRIF. RRIFs have a minimum withdrawal rate that must begin at the age of 71. The minimum rate is 5.28%, increasing every year – much higher than 4%.

Some suggest that the 4% rule be used as a withdrawal rate but not necessarily a retirement spending rate. Sure, you can withdraw 4% of your portfolio, but if you don’t spend it all in that year, putting it into savings (or better yet, your TFSA) can help smooth out those years with rougher returns. 

The only issue I have with this is the tax implications of withdrawing 4% of your portfolio. Depending on the size of your portfolio, this may lead to a hefty bill come tax time. Or it may have no impact at all.

How Much Can You Spend in Retirement?

I think the 4% rule is a good starting point when thinking about saving for retirement. But not necessarily the best number to be set on during the withdrawal or decumulation phase.

Here are a few other questions you may also want to consider when making your decision.

• What is your timeline for retirement? How long do you need your money to last after you retire?
• What is your portfolio asset allocation?
• What confidence level (or surety) are you comfortable with that your money will last?
• Are you comfortable adapting to your situation if circumstances or conditions change?

Your answers to the above questions can help determine your ideal safe withdrawal (and spending) rate.

Like me, you may also consider a variable withdrawal rate. With a variable withdrawal strategy, the amount you withdraw every year may differ based on your circumstances and overall market conditions. For this type of withdrawal to work best, it’s a good idea to have a cash cushion as part of your retirement accounts. Cash cushions can smooth out those years when the market is down so that you can avoid withdrawing as much for your investment portfolio.

When calculating how much you can spend (or withdraw) in retirement, it is also essential to factor in any investments you have outside your investment portfolio. Do you have a pension? Do you qualify for CPP or OAS? If so, at what age do you plan on taking them? These are serious questions to consider. A simple rule of thumb can gloss over that.

The 4% Rule Is Not That Simple Afterall

If all of this sounds overwhelming and the simple 4% rule is not that simple, you may consider working with a professional.

A certified financial planner can help you determine a safe withdrawal strategy so that you don’t outlive your investments. But be careful if the financial professional you work with relies on a rule of thumb of their own in determining your safe withdrawal rate.

And if all of this math intrigues you, but you’re not sure the 4% rule is for you, then you may consider running some Monte Carlo simulations on your portfolio. There are online platforms that can help you do this for free.