Can You Still Trust the Simple Old 4% Retirement Rule?

What the latest research says on this crucial question…

This question is a critical one for lots of people.

Perhaps you’re like me, in your early 60s, and want to retire in the next few years…

Or maybe you’re an adherent of FIRE – Financial Independence, Retire Early and want to know how much you need to set aside to pull the trigger…

Wherever you are in your financial journey, you need to know if you’re using the right tool, and crucially whether you’re using it correctly.

Where Did the 4% Rule Originate and What Does It Really Say?

In the mid-1990s, a then-obscure financial planner from California named Bill Bengen published a series of articles examining the safe withdrawal rates from a portfolio comprising 50% large-cap US stocks and 50% intermediate-term US treasuries.

He concluded that contrary to the 5% safe-withdrawal level then widely accepted, the safe initial withdrawal level for a 30-year retirement was just 4%.

He found that based on 38 rolling 30-year periods starting from 1926-1955 to 1963-1992, you could have drawn 4% of your portfolio in your first year of retirement, and each year adjusted for the prior year’s inflation and always had more than $0 at the end of 30 years.

Many People Misuse the 4% Rule

I’ve read about lots of different ways people use this “rule,” and many are simply wrong.

For example, fans of FIRE often use it to calculate how much they need to set aside to be able to retire early.

Wrong!

The 4% rule was never intended for a retirement longer than 30 years! 

If you retire at age 35, the Social Security Period Life Table says you have a 50% chance of living longer than 41 years if you’re a man and 46 years if you’re a woman.

If you retire at 40, you have a 50% chance of living longer than 37 years if you’re a man and 41 years if you’re a woman.

Retire at 45 and you still have a 50% chance of living longer than 33 years if you’re a man and 37 years if you’re a woman.

And these may all be underestimates since research has shown that life expectancy can be significantly longer if you’re wealthier than average (which you’d have to be if you amass enough to retire), if you’re not African American, and/or if your family tends to live longer.

4%-Rule Myths

Douglas Greenberg, President, Pacific Northwest Advisory, shares some common myths about the 4% rule that may lead to misusing it.

1. “It’s Guaranteed to Work: Due to market unpredictability, no withdrawal plan can provide a 100% guarantee of success.
2. “It’s Suitable for All Retirement Lengths: The 4% rule was derived for a 30-year retirement span. Early retirees or those planning for a longer retirement duration should adjust the rule.
3. “It Applies to All Asset Allocations: The 4% rule was based on 50% large-cap US stocks and 50% intermediate-term US treasuries. Other allocations (e.g., including non-US assets) may lead to different outcomes.
4. “It’s Inflation-Proof: While the rule adjusts draws for annual inflation, periods of hyperinflation may drain your portfolio faster than market returns accommodate.
5. “It Accounts for All Personal Expenses: The rule applies to withdrawals, not spending levels. Unexpectedly high expenses may force a higher draw that may later cause problems. 
6. “It Negates the Need for Regular Reviews: Periodic reviews of market conditions, personal needs, and other factors are essential to avoid problems in later years.
7. “It’s Universally Accepted: Various studies, including from Bengen, suggest lower or higher draw rates. View the 4% figure as a guideline rather than a universally agreed-upon mandate.

“In financial planning, understanding the nuances and underlying assumptions of any rule is vital. While the 4% rule offers a starting point, individual circumstances, evolving market conditions, and personal goals must always be considered.”

New Research Using Monte Carlo Simulations Offers an Updated Rule

The biggest problems Bengen faced were that (1) he only had 38 rolling 30-year periods to draw on, and (2) all of these looked at historic markets rather than what markets were expected to do in the future.

Current researchers avoid problem (1) by running 1000 or more simulations of market performance over 30 years and attempt to sidestep problem (2) by using current projections rather than counting on the future to be the same as the past.

Updating the 4% Rule

Morningstar recently published its annual State of Retirement Income report, looking at how today’s higher bond yields, lower stock market valuations, and moderating inflation impact starting safe withdrawal rates.

The report includes lots of intriguing information, but here, we’ll concentrate on their take on the 4% rule.

Looking back to the 1926-1992 period, they find that the worst 30-year period for the same 50/50 portfolio would have had a 90% chance of success with a 3.3% initial draw, while the best 30-year period would have allowed a 5.9% initial draw.

Looking forward, they turned to Morningstar Investment Management’s 30-year-forward expected returns, which, as of September 30, 2022, were 9.3% for large-cap US equities and 4.5% for US investment-grade bonds.

However, rather than use these to reconstruct Bengen’s simplistic portfolio, they assumed a more nuanced allocation.

For stocks:

• 30% large-cap US growth stocks
• 30% large-cap US value stocks
• 10% small-cap US growth stocks
• 10% small-cap US value stocks
• 20% foreign stocks

For bonds:

• 80% US investment-grade bonds
• 20% foreign bonds

For cash:

• 100% US treasury bills

The other critical factor they used was the expected average inflation over the coming 30 years, which they estimate at 2.84%.

For their version of a 50%-equities portfolio, they included 40% bonds and 10% cash.

The result?

The safe initial withdrawal for a 30-year retirement was 3.8%.

This is slightly lower than Bengen’s 1990s result of 4%. However, that slight difference could spell disaster for people using 4%.

Morningstar estimates that using a 4.1% initial draw instead of 3.8% reduces your likelihood of having enough money for a 30-year retirement shrinks from 90% to 86%.

This may seem like a minimal reduction, but if you happen to live through a scenario falling into that 4% difference (90% less 86%), you’d run out of money while still alive to experience sudden poverty when it’s too late to do anything about it.

Interestingly, the 3.8% safe initial draw stayed the same if you reduced your equity allocation to 30% (30/60/10 portfolio) or increased it to 60% (60/30/10). 

However, the “standard deviation,” or how widely results varied between scenarios, was far lower, with the 30/60/10 portfolio at 6.55% compared to the 10.45% standard deviation of the 60/30/10 allocation.

And in case you were hoping that more equities (or less) would improve on that 3.8%?

Sorry, but having 70% or more in stocks or 20% or less, your safe initial withdrawal is even lower.

Caveats

It’s important to keep in mind several things.

• The results are from simulations based on assumptions, so your real results may be better or worse than stated.
• The results assume you will always mechanically follow the process of drawing an inflation-adjusted amount equal to your initial dollar withdrawal, which was 3.8% of your starting portfolio. In reality, people tend to tighten their belts following a stock market crash.
• The results ignore research that shows retirees tend to reduce their real spending by about 1% per year.
• The results ignore any other income in retirement (e.g., Social Security benefits), assuming that you spend those plus what you draw from your portfolio.
• All of these studies aim at achieving a 90% chance of success. However, those who followed the 3.3% initial draw recommended by Morningstar’s 2021 report did not fare so well, given the market crash of late 2022 and the high inflation of that year, and now have a 78% chance of success. They may well be on the way to disaster. To have retained a 90% chance of success, they would have needed to draw less than 3%. 

The Bottom Line

To quote a quip from Nils Bohr, winner of the 1922 Nobel Prize in physics, “It’s hard to make accurate predictions, especially about the future.”

Unfortunately, when planning for retirement, we’re forced to do exactly that – predicting the future, and not just a year out, but many decades out.

The 4% rule attempted to use historic market returns to provide a safe initial draw that would never have resulted in running out of money over a 30-year retirement.

More recent studies use simulations and establish a 90% likelihood of success as the threshold for estimating a safe initial withdrawal. While last year that would have been 3.3%, Morningstar’s 2022 report suggests it recently improved to 3.8%.

You can still use the 4% rule as a guideline for a 30-year retirement, but not as an ironclad plan. 

Jon McCardle, AIF, President Summit Financial Group of Indiana agrees, “When we build a client plan, we use the 4% rule as a guide. Whenever we carry out quarterly reviews and updates, we also demonstrate a 3% withdrawal rate, so clients can mentally prepare and plan for what they’ll need in retirement and what they should do about it while they’re still working.

“Once a year, we provide a trajectory report showing their current assets, income, contributions, and company matching amounts. We then forecast 4%, 7%, and 10% hypothetical returns so they can see where they are and what they still need to do to get them where they need to go.”

Using the 4% number for planning early retirement, however, is hazardous to your financial health.

Even for “typical” retirement durations, such a static withdrawal model isn’t the safest path forward, as we’ll explore in future articles.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.

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Disclaimer: This article is intended for informational purposes only and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.