Everything You Wanted To Know About the Retirement Income 4% Rule

Today, I’d like to talk about the 4% rule. Maybe you’ve heard of it as the 4% rule, or possibly, the 4% retirement income rule. Or, maybe, simply as, how much can I take out of my portfolio in retirement?

Either way, there are many things about the 4% rule that most people don’t understand. In fact, I did an informal survey where I talked to clients and other financial advisors, and there seems to be quite a bit of discrepancy on what people think about the 4% rule, what they actually think it means and what it really means.

On this episode, I want to give you everything that you need to know about the 4% rule.

I did a Forbes article on this, where I came up with 17 items that I think most people don’t quite understand about the rule, so let’s jump in.

What is the point of the 4% rule?

The 4% rule is also called the Bengen Rule, and it’s only 25 years old. Why? William Bengen was a financial advisor, and in October of 1994, in the Journal of Financial Planning, he came up with a study titled, Determining Withdrawal Rates Using Historical Data. That was the name of the article that he published in 1994. So again, only 25 years old.

The 4% rule was initially calculated using a 30-year retirement timeframe. What does that mean? If you’re retiring, we need to know how much money you can pull from your portfolio. One of the big factors in determining that is how long you anticipate being retired for. Is it 5 years? 10 years? If you have a really short timeframe for when you’re retiring, then that means you could pull out a lot more money.

For example, imagine you have a million dollars in your retirement nest egg. Well, if you knew that your retirement was only going to last for 3 years, of course, that means you could withdraw a lot of money – hundreds of thousands of dollars – because it only had to last 3 years.

The question is: how long is your retirement going to last? If you retire at the average age, 65, what you’ll need to figure out is your life expectancy. If you retire at 65, how long will you live? That then answers the question of how long you’ll be in retirement.

When William Bengen did his analysis, he used 30 years. For better or for worse, he used 30 years as the timeframe. If someone retires at 65, that would put them at age 95.

Many of the people that I asked thought that the 4% rule means that you will never run out of money. That’s not exactly what the 4% rule says. The 4% rule is all about how much you can pull out of your portfolio to last 30 years – not 31, not 35, not 40. 30 years.

What does this mean for you? If you retire at 65, 70 or 75, maybe a 30 year timeframe is appropriate. But, if you’re lucky enough to retire earlier at 50 or 55, because life expectancy is increasing, because our healthcare is to the point where we can live much longer, that 30 year timeframe may not be enough. So, that’s something you need to put into consideration. The 4% rule is only looking at a 30 year timeframe.

This next item is the most misunderstood. Nobody that I asked actually got it right, and I not only asked individual investors, I also asked financial advisors. This one is very important. If you’re going to follow the 4% rule, you have to understand this. One of the most frequent misconceptions of the 4% rule is:

How to calculate the 4% 

You’d think this would be easy, but it’s actually very misunderstood.

What most people thought is that the 4% rule means I can take 4% of the balance of my portfolio each and every year, and that’s what I can live on. That’s actually not what it means.

Here’s the deal: if you had a million dollars in your retirement account and you were to pull 4% from it, that means you could take $40,000 from your retirement account as income. So, if the next year the portfolio had $1.1 million, then people thought, okay, what I need to do is take $44,000 that second year. This is actually is not true. You don’t calculate the 4% each and every year. Instead, you only calculate the 4% rule once: the first time, the first year of your retirement.

Let’s use that same example before. Imagine you’ve got a million dollars in your retirement account. That first year you take that 4% it’s $40,000. What happens the second year? Well at the start of the second year, we don’t look at your portfolio balance. We don’t care what your portfolio is. What we do, is we take that $40,000 that we calculated in that first year, and that’s how much you can take the second year, and the third year and the fourth year. There would actually be an inflation adjustment, but for right now, it’s that $40,000 each and every year. You are not taking 4% of your investment balance every year. You only do that once, the first year. So, even if that second year, your portfolio is $1.1 million, you’re still just taking $40,000. Or, if the portfolio had drop from a million dollars to $900,000, you’re not taking 4% of $900,000, you’re taking $40,000 each and every year, after you’ve calculated it the first time.

Now, let’s move onto the next item:

The inflation factor

What Bengen did is he also adjusted the 4% withdrawal rate for inflation. What that means is you take the $40,000 and figure out what inflation was for the previous year, and you add that onto the $40,000 you would be taking.

Let’s run through the numbers quickly using the previous example. We took $40,000 in the first year. Then, in the second year, again, we’re taking the $40,000, but we’re also increasing it by the previous year’s inflation rate. So, let’s imagine that the previous year’s inflation rate was 2.7%. What that would mean is in the second year, you’d be able to withdraw $41,080. How did I come up with that? It’s $40,000 plus the 2.7% inflation rate.

What William Bengen did, is for each and every one of those 30 years, he used actual data. He used the inflation rate of the previous year.

The question you may be having is, why? What not just use the 4% amount each and every year? Well, you could do that, but the problem is that because of inflation, because things cost more overtime, if you didn’t increase it by the inflation rate, it means that your purchasing power – that $40,000 – would decrease. For the first few years, that $40,000 would feel like $40,000. But, can you imagine what that $40,000 would feel like by year 25, 28 or 29? It wouldn’t have the same impact. You wouldn’t be able to buy the same amount of goods or services, because of inflation.

What Bengen said is listen, I want to keep your buying power static over that 30 year timeframe. And so, that’s why he increases it by the inflation rate each year. That’s something important for you to understand as well. If you are calculating your own retirement income, you calculate the 4% and then each and every year you get to increase it by whatever the inflation rate is. So, that’s definitely something to keep in mind, if you’re doing this yourself.

Historical simulations

What else? The other thing is that Bengen used actual historical simulations in his study. He wasn’t doing Monte Carlo analysis; Monte Carlo is basically looking at thousands (sometimes tens of thousands) of simulations. The simulations are not actual simulations of what has happened with Monte Carlo; you basically plug in some parameters, and within those parameters, you run simulations. That’s not what he did.

In Bergen’s study, he used actual historical returns, so for better for worse, the 4% rule uses historical returns for the calculations.

Rolling 30-year time periods

The 4% rule uses rolling 30-year time periods. What does that mean?

The Ibbotson Data (that’s the data that Bergen used – there’s lots of different sources of data) went back as far as January of 1926. So, here’s how to think about rolling timeframes.

The first 30-year rolling timeframe was 30 years starting in January of 1926. So, 30 years starting in 1926 would basically mean a timeframe of 1926 through 1955. The second rolling 30-year timeframe would be 1927 through 1956. The third rolling 30-year timeframe would be 1928 through 1957, and so on. So, those are 30-year rolling timeframes. That’s what he used when he calculated the 4% rule.

What else?

AKA the 4.15% rule

The 4% rule could also be called the 4.15% rule, because when he was calculating the highest withdrawal rate that we could pull from a portfolio for 30 years using historical data, it wasn’t actually 4%. It was 4.15%. So, that’s the actual amount. That’s the highest amount that he could pull from a portfolio over those 30 years without any risk of running out of money.

The SAFEMAX

Next is Bengen later termed the Maximum Sustainable Withdrawal Rate. That’s really what he was trying to figure out. What is the maximum amount of income that I can pull from my portfolio, the maximum I can take from my retirement portfolio, for a 30-year time period, using this historical data? That’s what he called the SAFEMAX: the safest amount and it’s the maximum amount he could pull in that 30-year time period.

If you’re reading about the 4% rule, you might see SAFEMAX. That’s something that he came up with, not in his initial article, this was something he coined later, but it’s important. The SAFEMAX. Again, it’s not the maximum amount over those 30-year rolling periods that he could pull, it’s the maximum amount without ever running out of money over any of those 30-year rolling time periods. That’s really the important piece for you to understand. In many of those 30-year periods, he could have pulled out more than 4% or more than 4.15%. In some of them, he could take out 5% or 6% and never run out of money for 30 years. But that’s not what he was trying to figure out. He was saying, let’s look at the history, and let’s look at over this long timeframe, what is the most I could take out and still not run out of money over any of the time periods that he looked at. So, that’s really very important when you’re thinking about the 4% rule. It’s the maximum amount that you can safely take out over a 30-year time period.

Here’s something else that a lot of people didn’t quite understand about the 4% rule – again, investors and advisors, alike.

Asset allocation

Bengen was running these scenarios and one of the important things he had to come up with in his study was, what should I assume is my asset allocation? Should I just assume that it’s all in cash? Should I assume that it’s all in stocks? Should I say 20% is in stocks and 80% is in bonds? That’s something that he had to come up with on his own. It was his study, he had to come up with a portfolio allocation. Here’s what he came up with: 50% stocks / 50% bonds. When you hear 4% rule, that is the asset allocation that he used. For stocks, he used the S&P 500 index. That was his index, how he allocated for the stock portion. For bonds, he used intermediate term government bonds.

The important thing for you to understand is that for any other asset allocation (other than 50% stocks / 50% bonds), you will get different results. That’s just something that you have to keep in mind. When you’re looking at how much money you can pull for your own retirement, understand, the 4% rule used 50% stocks / 50% intermediate term government bonds. Any other deviation from that might get different results – better or worse, it’s just going to be different. That’s something to consider and keep in mind if you’re doing this yourself.

What else?

The Trinity Study

Well, a few years after Bengen published his work, a group of three researchers replicated Bengen’s study. Their research was called The Trinity Study, and the reason it’s called this is because it was named for Trinity University, where the three authors were professors. But here’s something that they did a little different. Remember, Bengen used intermediate term government bonds – that was his proxy for bonds. The Trinity researchers didn’t use intermediate term government bonds, instead, they used long-term high-grade corporate bonds. Yes, they’re both still bonds, but they’re slightly different. Bengen used intermediate term, Trinity folks used long-term, Bengen used government bonds and the Trinity researchers used corporate bonds. Think it made much of a difference? Well, it actually did.

The results that they found using long-term high-grade corporate bonds is that the 4% rule didn’t work. A lower withdrawal rate was needed in order for that portfolio to last 30 years. So, what does this mean to you?

It just goes to show that if you change your asset allocation – even slightly, even using a different type of bond – then, it’s going to change the efficacy of the 4% rule. So, it’s really very important. I know I stressed this earlier, but it’s just really important. Your retirement asset allocation isn’t likely going to be exactly 50% in the S&P 500 and 50% in intermediate term government bonds. It’s most likely going to be something different than that – maybe, very different than that. And so, you can see that by simply changing the type of bond, the 4% rule didn’t work. So, when you’re doing these calculations yourself, just keep that in mind. Because we’re looking at a 30-year timeframe, if you make a minor shift or adjustment to your asset allocation, it can change whether the 4% rule will work for you or not.

That leads me to the next item…

What does it mean if the 4% rule works or doesn’t work? 

Bengen defined success as having any retirement asset at the end of 30 years, so, success would be having $4.25 million or $4.25 at the end of 30 years. Either way, it didn’t matter to Bengen. He said, listen, we’re assuming your retirement is 30 years. If you have a dollar left in that account at the end of 30 years, that’s great! It’s a success! The money lasted you 30 years. Even though you only had a buck left, that’s okay. Whether you had a dollar left or $10 million left at the end of 30 years, again, for the 4% rule, success is more than a penny leftover at the end of the timeframe. So, that’s important for you to consider. When you’re looking at your own retirement planning, how important is it for you to have assets leftover after you pass away, after you are finished with your retirement?

Maybe, you’re single and you don’t care about having any money left over. Maybe, you want to maximize the money that you have in retirement. Great! All you care about is making sure that you have enough income, enough assets, to last you 30 years. In that case, it doesn’t matter how much money you have left over at the end of 30 years. As long as you can pay that last bill before you pass away, that’s success to you. That’s great!

But what if you’re married? What if you have children? What if you want to leave an inheritance? Well, then it does matter, because again, the 4% rule is about how you can spend the most amount of money in retirement and be assured that you’re not going to run out of money. That’s a very different goal and objective than wanting to have a great retirement and wanting pull as much out as you can while retired, and (and this is the big and) still having $2 million left over to bequeath to your family or gift to a charity – whatever it might be. While that’s a very different objective than what Bengen and the 4% rule studied. So, that’s something to pay attention to when you’re doing these calculations for yourself.

Fund withdrawal

This is sort of minor, but it’s important. So, Bengen calculated that the retiree would withdraw funds annually. We know that, right? Remember the $40,000 in our example? But he calculated that the retiree would withdraw the money at the end of the year. Does that really make sense or seem practical?

Imagine you retire today, and you have a whole year’s worth of expenses ahead of you. Doesn’t it make sense to pull that money out at the beginning of the year, so that you can then pay for those expenses? I do. I think that makes more sense and is more practical and more realistic.

Now, when researchers are redoing this Bengen calculation, they will change it. They don’t assume that it’s at the end of each year. They pull it out in the beginning of each year. Again, something somewhat trivial, but it can actually make a difference when you are looking at these scenarios. So, that’s something to keep in mind.

Here’s another one…

100% success rate

When I did my informal survey, I asked people to tell me about the 4% rule. Many of the people that I asked said that the 4% rule means how much money I can pull out for retirement, and it has a 95% success rate. That’s what people had in their mind, a 95% success rate. Well, fortunately, this is not true. It doesn’t have a 95% success rate.

Think back to what I was talking about earlier. What was Bengen’s objective? He was interested in determining what is the highest inflation adjusted withdrawal amount over a 30-year period looking at historical data. The highest amount that you can pull out of the portfolio without running out of money for those 30 years. So, it’s that last piece – without running out of money – that’s key.

So, the 4% rule (or in his case, the 4.15% rule) had a 100% success rate. That was the entire purpose of his study. He wanted to know how much can I pull from the portfolio without having any risk of running out of money. Without having any risk means that he had a 100% success rate. Really important for you to understand that. In all of the historical, 30 year calculations, at any period you could take out 4% and have money left over. It had a 100% success rate.

50-75% stock allocation

No one would know this unless they actually read Bergen’s paper, but on page four of his 10-page paper, in large font letters, it read: 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%. What does this mean?

Keep in mind that Bengen was a financial advisor. His study was published in the Journal of Financial Planning, which is read by other financial advisors. So, this was a study that was really geared toward financial advisors and helping them advise their clients. He had this big caption, this big headline that said, when you’re working with clients, make sure that they have at least 50% in stocks, and ideally, closer to 75% in stocks for your retirees.

Why did he do this? Why did he say that? It seems pretty aggressive, doesn’t it?

Stocks are volatile – especially in the short-term. Many retirees view them as quite risky, in fact. Well, here’s what he found. The higher the allocation to stocks, again close to 75% to stocks, he was able to create a higher safe max withdrawal rate. What does that mean?

In his calculations, if he adjusted the asset allocation from 50% stocks / 50% bonds and increased it to 75% stocks / 25% bonds, he was able to show that you are actually able to take out more money from your portfolio. With a lower stock allocation, you could only take out a lower withdrawal rate – so, less than 4%.

This is really interesting. I think it’s very telling. He used an all bond portfolio in one of his simulations. He wanted to look at what would happen if a retiree was really conservative and put everything into a bond portfolio. What would that look like? How much could I then take out from my portfolio without having a risk of running out of money? What would you guess?

We know with 50% stocks / 50% bonds, you can take out a little over 4% without any risk of running out of money. What if it were 100% bonds? Can you take out 5% or more? Now, if you’ve been listening, you probably know that that’s not true. Again, remember he’s telling advisors to keep clients as close to 75% stocks as possible.

When he did the calculations with an all-bond portfolio, the maximum amount over this time period that they could pull out without running out of money was only 2.5%.

So, I know stocks can feel risky, and they are. They’re risky in the short-term. They’re volatile. But, this should show you that using this historical data, if you decide to become too conservative and shift all of your stocks into bonds, it will have an impact on how much you can safely withdraw from your retirement portfolio. So your investment allocation in retirement is really very important. How you are allocated will make a big difference in how much you can safely pull from your portfolio. You have to put a lot of attention and a lot of analysis into your asset allocation. It’s meaningful.

This next item sort of follows along what I was just saying.

The 4.5% rule

I said earlier that we can really call the 4% rule the 4.15% percent rule, because that’s really the amount that he discovered in that initial study. Well, guess what he did? He ran more studies after the initial study that he conducted, and you could probably now call it the 4.5% rule. Why?

In later research, Bengen included small cap stocks in his asset allocation. By including small cap stocks, he was able to increase the safe withdrawal amount from 4.15% to 4.5%. Why was this?

In his initial study, again, he was using the S&P 500. The S&P 500 is large US companies. Well, he decided he was going to use an allocation with some small cap stocks. Small cap stocks are a little bit more volatile in the short-term, but historically, what we’ve seen is they produce a higher average return over longer periods. Because of that higher average return, he was able to increase the safe withdrawal amount from 4.15% to 4.5%.

As the listener, you might be thinking, well, somewhere between 4-4.5% is how much I can pull from my portfolio that first year. If I’m too conservative though and have too much in bonds and not enough in stocks, I know that that safe withdrawal amount is going to be less than 4% – maybe in the 2-2.5% range. It could even go lower than that because interest rates are so low right now. We need someone else to study what it would be if we used current interest rates. It might be closer to 2% withdrawal rate.

Again, I know I’ve been harping on this, but when you’re doing your own withdrawal rate and retirement income planning, you really have to look at your asset allocation. How much do you have in stocks? How much do you have in bonds? What kinds of stocks and bonds do you have? Run the analysis really using your own asset allocation, because that will tell you, based on what I have as my asset allocation, what can I safely withdraw from my portfolio, without having a risk of running out of money.

Okay, the last item (and I just hinted at this one).

The impact of low interest rates

Some researchers now, for example, Dr. Wade Pfau (he was actually one of my retirement planning professors in my PhD program), have suggested that the 4% rule might be too generous. Why is that? Why might the 4% rule be too much now, versus when Bengen did this study in 1994?

Well, we have to look at where we were in 1994. When he did this study and when he looked at the historical returns of stocks and bonds since 1926, the interest rates on bonds were much higher over that time period than it is today. Because our interest rates today on bonds are much lower, Dr. Pfau and other researchers studying this have said that the 4% rule might not be a safe withdrawal rate if low interest rates persist. This is significant and something to keep in mind as you figure out your own safe withdrawal rate.

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So, I will leave you with this: The 4% rule is a great place to start when you are thinking about how much money you can safely withdraw from your retirement portfolio; however, you shouldn’t rely on it exclusively. Trust me! The 4% rule used specific assumptions, as I’ve talked about today, that may or may not apply to you. There are many factors to take into consideration when determining how much you can safely pull from your retirement accounts. A slight shift in any of these factors… what are these factors? While, here are just a few:

• Expected investment returns
• The length of your retirement (Remember, Bengen used 30 years. You might use something longer than that)
• Your desire to leave an inheritance
• Inflation rates
• Sequence of returns

All of these can make a big difference in your overall retirement income plan. So, retirement should be a time when you’re free to do the things that you want, so you can enjoy life. Nobody wants to retire, only to be stressed out about their finances or worried that they’re going to run out of money. You want to create a retirement income plan that gives you confidence so you can truly enjoy spending time and spending your money doing what you love, instead of being focused on your portfolio or the craziness that’s going on in the stock market.

So, I hope you’ve enjoyed this snapshot of what the 4% rule is all about. I hope you learned a few things. If you have any questions, I would love to start answering some of those on this podcast. Questions about the 4% rule, questions about asset allocation, questions about retirement income, questions about retirement – all of your retirement questions, I would love to address here on this podcast. So, please, send me an email at robert@pacificawealth.com.

I look forward to getting your questions, and I look forward to the next podcast.