3 Serious Problems With the 4% Retirement Rule

By Selena Maranjian Markets Fool.com

As you plan for retirement and form an educated estimate of how much money you'll need, part of your calculations will involve determining how much of your savings you can withdraw each year, while still making your money last. The famous "4% rule" can help with that, but it's not without some flaws.

Continue Reading Below

Meet the 4% rule

The 4% rule has been around for a long time. It was introducedby financial advisor Bill Bengen in 1994 and was made famous in a studyby several professors at Trinity University a few years later. It says that you can withdraw 4% of your nest egg in your first year of retirement, adjusting future withdrawals for inflation. This withdrawal strategy assumes a portfolio 60% in stocks and 40% in bonds, and it's designed to make your money last through 30 years of retirement.

Image source: Getty Images.

Here's an illustration of how it works: Imagine that you've saved $500,000 by the time you retire. In your first year of retirement, you can withdraw 4%, or $20,000. In year two, you'll need to adjust that rate by inflation. Let's say that inflation over the past year was at its long-term historic rate of 3%. You'll now multiply your $20,000 withdrawal by 1.03 and you'll get your second year's withdrawal amount: $20,600. The following year, if inflation is still around 3%, you'll multiply that by 1.03 and get your next withdrawal amount, $21,218.

The 4% rule can also help you estimate how much you'll need to accumulate in the first place -- once you know how much annual income you'll want in retirement. Let's say, for example, that you'd like to start retirement with total annual income of $60,000 and you expect to collect $25,000 from Social Security. That leaves $35,000 in income that you'll need to generate on your own. If you assume that $35,000 is 4% of your nest egg, then you can multiply $35,000 by 25 in order to arrive at how large your nest egg will need to be: $875,000. (Why 25? Because one divided by 0.04 is 25.)

Continue Reading Below

So what's the problem with this seemingly super-helpful rule? Well, unfortunately, several things.

Interest rates have fallen: For starters, remember that the rule was created more than 20 years ago, when interest rates were higher. Mortgage rates in 1994 were in the 8%range, and one-year CDs paidabout 4%. In such an environment, the bond portion of a portfolio would have been generating more income than bonds do today. (A two-year government bond recently yielded1.2%.) We've been in a low-interest rate environment for a long time now, rendering our bonds less able to replenish funds withdrawn each year.

Image source: Getty Images.

It assumes a certain asset allocation: Then there's the rule's assumption that your portfolio will be split 60-40, respectively, between stocks and bonds. You might not have or want that allocation. If your portfolio is split 50-50, or you have 75% of it in stocks, then the 4% rule won't work as advertised.

People are living longer: Datafrom a 2015 Centers for Disease Control and Prevention report shows that those born in 2014 can be expected to live, on average, to age 78.8, up from 75.8 in 1995 and 70.8 in 1970. And those are just averages -- many people live much longer lives and some live much shorter ones. The 4% rule aims to make your money last for 30 years, but if you retire at 62 and live to 96, your retirement will be 34 years long and you might be quite pinched in your last years.

Image source: Getty Images.

Should you use the 4% rule?

Clearly, the 4% rule is flawed. But you don't necessarily have to throw it out altogether.

If you think you stand a decent chance of having a retirement that's more than 30 years long, you can be more be more conservative, perhaps using a 3% or 3.5% withdrawal rate -- at least in your initial years. That can be helpful during our low-interest rate environment, too. (Interest rates have begun inching up, but no one knows when they will hit various levels.) Don't be too rigid about it, though. If the market grows briskly in your first few years, you can re-evaluate and perhaps increase your withdrawals.

Another challenge regarding the 4% rule is that every set of 20 or 30 or however many years in the stock market will be at least somewhat different -- some with higher-than-average gains and some with lower-than-average gains. If you plan to follow the rule and withdraw 4% of your nest egg in your first year of retirement, you'll be at a disadvantage if the stock market crashed in the year leading up to your retirement. Such things can happen: The S&P 500 plunged 37% in 2008. If that happens early in your retirement, you'll either be withdrawing far less than you'd planned on or you'll be depleting your nest egg faster. You can address this stock market-volatility issue by being flexible -- withdraw less in bear markets and more in bull markets.

It's a good idea to reassess your financial condition regularly during your retirement, too. For example, if when you're 80 you don't think you'll be around in a decade and your coffers are rather full, you could start withdrawing and enjoying more each year -- or just plan to leave more to your loved ones.

We all need to plan carefully for retirement. The average monthly Social Security retirement check is only $1,360 (or about $16,000 per year). You can boost your Social Security income via some strategies, but you'll probably still need a separate nest egg of your own, and a plan to make it last. The 4% rule can be helpful for that, but use it wisely.

The $16,122 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after.Simply click here to discover how to learn more about these strategies.

The Motley Fool has a disclosure policy.