Understanding the 4% Rule for Sustainable Retirement Income
By Michelle Clardie on 09/19/2024.
Reviewed by Josefin Gatsby
Will your retirement savings provide enough income to sustain your lifestyle during retirement? How can you be sure?
Having too little in savings, or spending too much during your golden years, could cause you to run out of money during retirement. And what would happen then? Would you go back to work? Or rely on the financial support of family and friends? Neither option is ideal for most retirees. That’s why it’s so critical to make sure you save enough money for retirement and use those funds responsibly once you’re retired.
Of course, to do that, you need to know how much you can spend each year during retirement to prevent your funds from running out.
In the 1990s, financial analysts created a formula to ensure that savings would fund around 30 years of retirement. This formula became known as the 4% rule.
What is the 4% Rule in Retirement Investing?
The 4% rule is a financial strategy for retirement in which you withdraw 4% of your retirement savings in your first year of retirement and adjust that 4% base amount for inflation each year after.
The purpose of the 4% rule is to make sure you can financially support yourself throughout retirement. With this approach, most retirees can expect to make their retirement savings last for around 30 years.
This is a simple strategy, designed to work for all retirees, regardless of retirement savings. No matter how much you have saved, as long as you use 4% as your base withdrawal amount, you should be able to make your retirement savings last for 30 years or more.
How the 4% Rule Works
During your first year of retirement, you would withdraw 4% of your total retirement savings to cover living expenses for that year. This 4% is your base withdrawal amount. The rest of your retirement savings remains invested so it can continue growing in value year by year.
Next year, this amount will be adjusted for inflation. If, for example, inflation increases by 3%, you would add 3% to your base amount to determine how much you should withdraw for that year’s living expenses.
This amount, adjusted for inflation, becomes your new base amount. So for year three, you will adjust this new amount for inflation. And you’ll continue in this way throughout retirement.
Theoretically, years with higher inflation will also provide better returns on your retirement account investments. So your growing funds should be enough to cover the inflation increases.
Example of a 4% Rule Calculation
Let’s say you’re ready to retire, and you have a retirement account of $3 million.
Using the 4% rule, you could withdraw $120,000 to cover the living expenses for your first year of retirement ($3,000,000 x .04 = $120,000).
The next year, you adjust this $120,000 base for inflation. If, for example, inflation is 3%, you would withdraw $123,600 ($120,000 x 1.03 = $123,600). This $123,600 becomes your new base value.
The next year, you adjust the new base value of $123,600 for inflation. If inflation is 2%, you will withdraw $126,072 ($123,600 x 1.02 = $126,072).
This 4% rule formula continues throughout retirement.
Limitations of the 4% Rule
The 4% rule isn’t perfect. It does not account for:
Medical expenses. Healthcare costs are unpredictable. They depend largely on how healthy you remain as you age.
Sudden market shifts. The 4% rule relies on the performance of your investments. A recession, for example, could eat into your available funds while a boom could provide much more money than originally expected.
Income taxes. Income tax liability varies from one household to another, depending on income brackets and the types of retirement accounts and investments held.
Alternative investments. The 4% rule was designed around a specific portfolio mix (typically 50-60% stocks and 40-50% bonds), so alternative investments may affect the 4% rule’s effectiveness.
How Did 4% Become the Agreed-Upon Number?
The 4% rule was developed in 1994 by financial planner William Bengen. He analyzed historical market data from 1926 to 1976, looking at various 30-year periods of stock and bond performance, and determined that 4% was a safe withdrawal rate for retirees.
Bengen found that those who withdrew 4% of their initial portfolio and adjusted for inflation each year would generally not run out of money over a 30-year retirement. This finding held true even in periods of financial distress, like the Great Depression.
This research became widely accepted as a general guideline for retirees.
Pros and Cons of the 4% Rule
The 4% rule for sustainable retirement income has advantages and disadvantages.
The benefits of using the 4% rule include the following:
Simple calculations. There are no complicated formulas or algorithms to worry about. Simply multiply your base amount by 4% each year.
A predictable income stream. You’ll enjoy a stable income to cover living expenses through around 30 years of retirement.
Historical success rates over a 30-year retirement period. This rule has been proven to work for all 30-year periods for over a century.
The potential downsides of the 4% rule include the following:
You could run out of money if your retirement lasts more than 30 years. If you plan to retire early or end up living longer than expected, the 4% rule may not provide enough income.
It doesn’t account for unexpected increases in expenses. If your cost of living goes up dramatically, 4% may not be enough to cover your expenses. For example, if you rent during retirement, rental increases could nullify the 4% rule. Medical issues are also a concern, which is why it’s so important to have appropriate insurance coverage in retirement.
The Dividend Spending Rule as an Alternative to the 4% Rule
If you’re not comfortable with the 4% rule due to its limitations, you might consider the Dividend Spending Rule as an alternative.
The Dividend Spending Rule says you should only spend the dividends (income) generated from your investment portfolio, preserving the principal amount. This gives you a steady income stream without diminishing the value of your retirement assets.
This strategy offers a few key benefits over the 4% rule:
You will not run out of money, no matter how long you live.
You can retire early, knowing that your investment income will sustain you.
This method works better than the 4% rule for alternative investments, including real estate.
Let’s say you have a real estate investment portfolio that generates $8,000 per month in passive income. With the dividend spending rule, you can use this $96,000 per year to cover your living expenses throughout retirement.
While some holding costs may increase over time (like property taxes, insurance, and maintenance), rental rates trend up with inflation, theoretically allowing you to maintain or even increase your margins.
No matter how early you retire, or how long you live, you’ll have this income to live on. And you’ll have valuable assets to pass along to future generations! This is the epitome of lifelong financial freedom.
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