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Understanding the 4% Rule for Retirees

The 4% rule is a useful starting point for retirement planning, but it's crucial to understand the assumptions behind it

Christine Benz 23 July, 2012 | 4:59PM

The so-called “4% rule” has been in vogue for almost 20 years now, taking off in popularity since financial planner William Bengen introduced his research in 1994. This rule, based on back-tested data, outlines that retirees withdrawing 4% from their portfolios per year for 30 years had a low probability of running out of money during their lifetimes. Several years later, the Trinity study, so named because it was authored by three professors at Trinity University in 1998, looked back at market data and generally corroborated Bengen's findings. The study concluded that retirees using a 3%-4% withdrawal rate, combined with annual inflation adjustments, had a good chance of not running out of money during a 30-year period.

Some critics, notably William Sharpe and a team of researchers from Stanford, have since assailed the 4% rule as being too simplistic; others have asserted that Bengen's assumptions about asset allocation were too aggressive for many retirees. Financial planner Michael Kitces has argued in favour of a withdrawal rate that's sensitive to market valuations. More recently, critics have said the 4% rule is too ambitious given the feeble return expectations for the bond market as foretold by today's tiny yields.  

Although the debate about safe withdrawal rates is alive and well, I'd argue that the 4% rule isn't an unreasonable starting point for retirees and soon-to-be retirees attempting to gauge whether their spending is sustainable. Importantly, the rule is intuitive--you don't have to be a pocket-protector-wearing owner of a financial calculator to see if your nest egg and spending rate are close to where they need to be. And, to the extent that 4% is a fairly conservative withdrawal rate, it helps shield against the biggest of all risks that retirees face: running out of money during their lifetimes.

That said, successfully employing the 4% rule requires that you understand the assumptions behind it, including the following:

Where Is the Money Coming From?
When it comes to the 4% rule, "withdrawal rate" is something of a misnomer, because you're not necessarily invading your principal to generate the entire 4%. Instead, the 4% can come from bond and dividend income, capital gains distributed by various funds, or selling securities.

Say, for example, you're about to retire with a £1.5 million portfolio, 40% of which is in bonds and the rest in stocks. Using the 4% rule, your initial withdrawal in year one of retirement would be £60,000. Assuming a 3% income distribution from your £600,000 bond portfolio (£18,000) and a 1.5% dividend yield from your £900,000 in stocks (£13,500), that's £31,500 in bond and dividend income that you could tap before touching your principal. The flexibility to draw your money from a variety of sources--and to not take sides in the income versus total return debate--is one reason that a "bucket" approach to retirement income can make sense for so many retirees, as I argued in my article Income vs. Total Return: Why Take Sides?

The Role of Asset Allocation 
In addition to understanding that the 4% rule doesn't always necessitate selling off assets, investors should also be aware that a 4% withdrawal rate won't automatically be sustainable for each and every asset allocation, particularly ultraconservative stock/bond mixes that generate low real returns. Both Bengen's research and the Trinity study found that portfolios with a mix of both stocks and bonds had the highest probability of long-term sustainability. The reason? Even though retirees may have to tap capital to arrive at their 4% payout, appreciation from the stock component could help offset inflation and periodic invasions of principal, while bonds provide ballast for the equity piece.

Bengen's original research asserted that an optimal starting allocation when applying a 4% withdrawal rate was 50%-75% equity, whereas the Trinity study authors, in an update to their original study, corroborated that a starting asset allocation of 50% or more in large-cap stocks helped retiree portfolios achieve the best probability of not running of money. Making room for a healthy component of equities looks especially important right now, given increased longevity as well as the ultralow yields available from fixed-income securities.

Time Horizons
Like asset allocation, a retiree's time horizon also plays a critical role in the sustainability of a withdrawal rate. Bengen's research looked at the viability of various withdrawal rates and asset allocations over drawdown periods of 30 years, whereas the Trinity study evaluated withdrawal rates over periods of 15, 20, 25, and 30 years. In general, the Trinity study showed that investors with shorter holding periods could employ a higher withdrawal rate than those with longer holding periods. That finding has implications for those who have longevity on their side (they'd want to be more conservative about their withdrawal rates), as well as for those who have reason to believe they have shorter time horizons. (Such individuals could reasonably employ more aggressive withdrawals.) 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Christine Benz

Christine Benz  is director of personal finance at Morningstar and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances.