The 4% rule of retirement is one of the most frequently cited guidelines for retirees to determine a safe withdrawal rate from their savings. The basic concept is that if you withdraw 4% of your retirement savings during your first year of retirement and increase this amount in subsequent years to keep up with inflation, you shouldn't run out of money during your retirement.
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While the 4% rule is certainly a handy guideline, it does have several shortcomings that investors should be aware of. Specifically, here are four problems that you need to account for when applying the rule to your own retirement planning.
1. The rule was developed when interest rates were much higher
The 4% rule of retirement was developed more than 20 years ago and first published by William Bengen in 1994. At the time, interest rates were much higher than they are today, as you can see in this chart of 10-year Treasury bond yields.
The basic idea behind the 4% rule is that while you're taking withdrawals that increase every year, your portfolio's returns will sufficiently replenish your account value so that you won't have to worry about running out of money during retirement. However, since the rule suggests that roughly half of retirement assets should be in bonds, low interest rates could generate lower-than-expected portfolio returns, which would deplete the account faster than the 4% rule assumes it will.
In fact, Bengen's original paper assumed 5.2% average returns from bonds, which is in line with the long-term historical average but is not a realistic expectation in the current environment.
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2. The 4% rule assumes a retirement length of 30 years or fewer
Another major shortcoming of the 4% rule is that it is designed for a 30-year retirement -- and for many people, this is certainly the case.
However, in the 23 years since the rule was first published, life expectancies in the U.S. have increased significantly, and people living into their 90s or even 100s is a much more common occurrence than it once was. According to Vanguard, there is a 45% chance that at least one spouse in a 65-year-old married couple will live to 90, and an 18% chance that one of them will make it to 95. In other words, even if you retire in your mid-60s, there's a significant chance that your retirement will last longer than 30 years. If it does, following the 4% rule could result in running out of money.
The same can be said if you plan to retire early. If you retire at 55, living until 90 translates to a 35-year retirement. Early retirees would be wise to adjust the 4% rule downward to compensate.
3. The 4% rule assumes a relatively high stock allocation
The 4% rule was formulated by using certain theoretical asset allocations and testing them in different hypothetical scenarios. One finding is that an allocation of at least 50% stocks is ideal for portfolio longevity. As Bengen wrote: "I think it is appropriate to advise the client to accept a stock allocation as close to 75% as possible, and in no cases less than 50%. Stock allocations lower than 50% are counterproductive, in that they lower the amount of accumulated wealth, as well as lowering the minimum portfolio longevity."
While most experts advise retirees to keep some of their assets in stocks, this would be a pretty aggressive asset allocation by most standards. For example, the oft-used "110 rule" says that by subtracting your age from 110, you can find your appropriate stock allocation. This would suggest that a 70-year-old retiree should have 40% of their portfolio in stocks, which is contradictory to Bengen's 4% rule assumptions.
In addition, consider that the Vanguard Target Retirement Income Fund (NASDAQMUTFUND: VTINX) maintains a 30%/70% stock and bond allocation and is a popular all-in-one investment option for retirees.
In a nutshell, the 4% rule assumes a much more aggressive asset allocation to achieve adequate returns to make the portfolio last throughout retirement.
4. Losses early in retirement could make the 4% rule less effective
One problem with the rule, which is particularly concerning if a retiree maintains a stock-heavy asset allocation as the 4% rule suggests, is that early losses could derail the rule.
Think of it this way: Let's say that you have a $1 million retirement portfolio and maintain 60% of your assets in stocks. If a 2008-style crash occurs and the S&P loses 38% in a year, even if your bond investments hold their value, your account could be worth less than $800,000 after such a crash. Continuing to make inflation-adjusted withdrawals based on 4% of the account's original $1 million value could deplete your nest egg at an unsafe rate.
The bottom line on the 4% rule
To be perfectly clear, I'm not saying that the 4% rule of retirement is worthless -- quite the opposite, actually. I often quote the 4% rule in articles to help people estimate how much they need to save for retirement.
What I'm saying is that the rule has several shortcomings that could require a slight modification to the 4% withdrawal rate. For example, if you plan to retire at age 50, you may be better off with a 3% or 3.5% withdrawal rate to compensate for a longer expected retirement. Or if the market crashes after you've been retired for a year or two, it can be a good idea to adjust your 4% figure to your account's new balance.
The bottom line is that the 4% rule of retirement is a good starting point, but it's not a one-size-fits-all solution. Your personal situation and the current economic climate need to be taken into consideration, as well, to determine your safe retirement withdrawal rate.
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