The 4% Retirement Spending Rule — What You Need to Know

Key takeaways:

• The 4% rule is a widely used personal finance guideline that suggests a sustainable withdrawal rate from retirement savings.
• The rule adjusts the withdrawal amount for inflation each year and aims to ensure that retirees stay within their savings.
• The 4% rule has limitations and should be used as a guideline and tailored to an individual’s unique circumstances and sources of retirement income.

The 4% retirement spending rule, also commonly known as the 4% rule of retirement, or simply as the “4% rule,” is one of the most common personal finance guidelines used by financial planners. The goal is to recommend a sustainable withdrawal rate from a client’s retirement savings.

Here’s the basic idea. The 4% rule says that in your first year of retirement, you can comfortably withdraw 4% of your retirement savings. In future years, you would adjust this amount for inflation, So, if the inflation rate is 6% in 2023, you would withdraw 6% more than you did in 2023.

Theoretically, if you do this you have an excellent chance of not running out of money for at least 30 years. In a nutshell, the 4% retirement spending rule is designed to ensure that you won’t outlive your retirement savings. According to William Bengen, who is credited with formulating the 4% rule, “Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe.”

Example of the 4% rule

Let’s consider an example of how this withdrawal strategy works. Let’s say you have $1 million in retirement savings, including 401(k)s, IRAs, and other types of retirement plans.

If you retired on Jan. 1, 2023, you would withdraw 4% of this amount, or $40,000, from your retirement savings to fund your living expenses during your first year of retirement. To clarify, you could either take this amount as a lump sum or as a series of withdrawals throughout the year, whichever is the best fit.

If inflation ends up being 5% in 2023, you would apply this adjustment to your initial withdrawal, which would increase the amount to $42,000 for 2024. In subsequent years, you would apply adjustments based on the prevailing inflation rate.

There are several different ways to determine the inflation adjustment to apply to your withdrawals each year, but one easy way is to use the annual Social Security cost-of-living adjustment (COLA). This is designed to help seniors keep up with inflation and is based on consumer price index (CPI) data.

Shortcomings of the 4% rule

The 4% rule is certainly a good guideline for retirement planning, but like most financial planning rules of thumb, it isn’t perfect. This isn’t to say the 4% rule isn’t right for you, but it’s important to know a few drawbacks before you use it.

The 4% rule is less effective in low-interest environments

When the 4% rule was originally written, it assumed investors could achieve annualized bond returns of more than 5%. That’s certainly true as we head into 2023, but it hasn’t been the case for much of the past 20 years. Since the entire premise of the 4% rule is that your portfolio will replenish itself to make up for your retirement withdrawal rate, this means that when interest rates are at rock-bottom levels, the 4% rule could be too aggressive.

The 4% rule doesn’t consider other retirement income

Not every retiree needs to withdraw 4% of their savings each year to cover retirement spending. What if you have a large pension from a job, or a high social security benefit? Or, what if you are still working part-time well into your 70s? What if you have a lot of money saved in non-retirement accounts?

It’s important to note that the 4% rule is a guideline of how much you can withdraw. It doesn’t necessarily mean that you should.

Early losses can be tough to overcome

This is a big one. What happens if you withdraw $40,000 of a $1 million retirement account in your first year of retirement, and then the stock market crashes? Next year you’ll be pulling out even more money from a much smaller nest egg.

One of the biggest shortcomings of the 4% rule is that it is largely based on historical data and mathematical averages of market conditions over time. If the value of your retirement assets suddenly plunges, you may need to rethink your withdrawal amount until a bear market is over.

Is the 4% rule of retirement right for you?

The bottom line is that the 4% retirement savings rule is a good guideline but should not be treated as a set-in-stone rule. Every retiree is different. If you plan to retire early, or there’s a low-interest environment when you retire, a somewhat lower withdrawal rate might be safer. The best move is to talk with an experienced financial planner about your unique situation and tailor a retirement savings withdrawal rate that works for you, and to be adaptable to changing economic conditions over time.