Since the mid-1990s, the 4% rule has been a gold standard in retirement planning. Its simplicity is the key to its appeal because it helps answer a challenging and complex question: How much can you spend each year in retirement?
While the 4% rule is a great starting point for your retirement planning, it's flawed as a stand-alone strategy because its simplicity leaves too much room for error. The reality is the market and economy are volatile at times, which creates blind spots that could get retirees in trouble.
Here's how you can tweak the rule to improve it and ensure your retirement goes according to plan.
What is the 4% rule?
William Bengen, a retired financial advisor, created the rule as a "North Star" for retirement savings. Bengen based it on historical investment data related to stock and bond market performance from 1926 to 1976. The goal of the rule is to make sure people can stretch their retirement savings for as long as needed without the risk of running out of money.
The 4% rule is wonderfully simple. It states that an investor can withdraw 4% annually (adjusted for inflation) from a portfolio of 60% stocks and 40% bonds, and expect their savings to last at least 30 years. For example, consider a $1 million nest egg. John or Jane Doe should be able to withdraw $40,000 in year one. If inflation ends up being 3% that year, they would withdraw $41,200 in year two, and so forth.
It's understandable why it became such a popular rule: It helps retirees grapple with a very complex topic and is strikingly easy to implement. But its ease of use has resulted in people depending on the rule as a stand-alone retirement strategy, and unfortunately, it's just not that simple.
What are its flaws?
For starters, the market can be very volatile from year to year, which can cause uneven withdrawals. For example, suppose you withdraw $40,000 from that $1 million portfolio in year one. However, in addition to your withdrawal, the market experiences a sharp downturn, and your portfolio value falls 30% to about $670,000. That $41,200 you withdraw in year two (adjusted for the 3% inflation) takes a 6.1% bite out of your nest egg. Meanwhile, there's no way to know how long the market will take to bottom out or recover.
The opposite can also happen: Your portfolio keeps growing, and your fixed amounts can leave too much on the table. You might not want to reach the end of your life with a ton of money left over that you could have enjoyed had you been a bit more aggressive with your withdrawals.
This is especially relevant as the elderly face surging healthcare and assisted-living costs. These expenses are growing far faster than overall inflation. Left unchecked, your quality of life can deteriorate as these expenses consume an increasingly significant portion of your annual income.
Add a little flexibility to your plans
One solution is to put a cap and floor on what your annual withdrawal can represent as a portion of your portfolio. For example, consider using the 4% rule to find a baseline number. Each year, calculate what that baseline withdrawal will represent as a percentage of your portfolio value at the time.
Think back to the previous example where a market crash caused the baseline number to represent a 6.1% withdrawal. A 5% cap might temporarily restrict your income for that year, but it would also protect your nest egg from drying up ahead of schedule.
Conversely, you would withdraw more in an up-year for your portfolio, giving you a financial buffer and preventing a prolonged bull market from leaving too much of your portfolio on the table over time. The good news is bull markets historically last longer than bear markets, so you're more likely to end up with a surplus any given year than having to tighten your belt.
The 4% rule is a solid starting point, but getting the most out of your retirement will require more planning and flexibility. Don't hesitate to consult a professional advisor for specific advice and planning strategies for your situation.
