The 4% Rule, Explained
If you have spent any time reading financial independence blogs or listening to podcasts in the last decade or so, you’ve probably heard about the 4% rule. Or maybe you haven’t heard of it or you are just a little confused about what it means or how to apply it. Hopefully this post can clear up some of your confusion.
Understanding the 4% Rule
The 4% rule is based on research done by William Bengen in 1994.1 Similar research has also been completed since the initial publication by Bengen, most famously the Trinity Study in 1998, by 3 professors from Trinity University.2 Both studies used historical stock and bond data, dating back to 1926, in an attempt to determine the maximum safe withdrawal rate so that the investor/retiree would never run out of money during their lifetime.
Spoiler Alert! Both determined this number to be around 4%. More specifically, they stated that, based on a 30 year retirement, the most a person could safely withdraw from their accounts was 4% per year, calculated based on the value of their portfolio at the time of retirement, and adjusting only for inflation in each subsequent year.3
This all sounds great, but this analysis was performed over 20 years ago. How well does it stand the test of time and how relevant is it for early retirees today? Let’s take a closer look at the analysis.
The assumptions used for the analyses were very similar in both studies and are summarized below:
Withdrawal rates of 3% to 12% per year were analyzed
Withdrawal amount was calculated in the first year taking the subject percentage of the total portfolio value. In subsequent years, that same withdrawal amount was used, but it was adjusted for inflation or deflation.
Each withdrawal rate was evaluated using many different portfolio distributions of stocks and bonds, from 100% stocks all the way to 100% bonds
The studies assumed that the stock/bond allocation was re-distributed regularly to the stock/bond allocation was used initially.
The scenarios were evaluated assuming hypothetical retirements spanning 30 years starting in every year from 1926 through 1976. The date range is significant because it factors in the huge downturns of the great depression (1929 to 1931), the World War 2 years (1937 to 1941), and the 1973 to 1974 recession.
The results of the Bengen and Trinity Study for a 30 year retirement length are listed in the tables below. The tables show the chances of success (in %) of withdrawal rates vs. bond/stock mix. In this case, success is defined as having any money left over after 30 years. As is evident from the table, not only is the success rate highly dependent on withdrawal rate, but the stock/bond allocation matters as well. The data suggests that to have the best chance of making your retirement funds last for 30 years you would want a withdrawal rate of between 3% and 4% (closer to 4%) and a portfolio with a stock allocation of between 50% and 100%. With stock allocations below 50%, the portfolio does not benefit as much from the upside potential and growth of the market. At the time of the first study by Bengen, the success rate of the high stock percentages went against the conventional wisdom, which was to reduce stock exposure in your later years. Even today, many people would be nervous keeping 75% of their retirement funds in stock holdings once that becomes their main source of income. The good news is that the studies also showed that the likelihood of success does not change greatly between 50% and 100% stock allocation.
Table 1: Bengen Study - 30 Year Portfolio Success Rate - Assuming Inflation Adjusted Yearly Withdrawals (1926 to 1997)
Table 2: Trinity Study - 30 Year Portfolio Success Rate Assuming Inflation Adjusted Monthly Withdrawals (1926 to 1997)
Methodology Differences Between the Studies
While the data from each of the studies is very similar and generally supports the other study, there are some subtle differences in the assumptions made, including:
Historical Data Used
Bengen used common stocks (likely S&P 500) and intermediate-term treasury bonds from Ibbotson Associates' Stocks, Bonds, Bills and Inflation: 1992 Yearbook.
Trinity Study used the S&P 500 for stocks, Long-Term High-Grade Corporate Bond Index and Standard & Poor's monthly high-grade corporate composite yield for bonds
Rebalancing of Portfolios
Bengen assumed once per year rebalance to the original allocation
Trinity Study assumed once per month rebalancing to the original allocation
Payout Periods (Retirement Duration)
Bengen based the success criteria for a 30 year retirement, but his bar graphs provide some data for portfolios up to 50 years.
The Trinity Study also evaluated shorter retirement periods than 30 years, but those are not discussed in this article as they are not as relevant to an early retirement scenario
Inflation Adjustment
Trinity Study looked at non-inflation adjusted withdrawals in addition to inflation adjusted. The non inflation adjusted withdrawals allow for a higher initial yearly withdrawal, but don’t adjust for inflation. (Non inflation adjusted withdrawals not shown in this post)
Withdrawal Frequency
Bengen looked at yearly withdrawals
Trinity Study looked at monthly withdrawals. In the publication from the Trinity Study, it is mentioned that the results yield slightly less success using monthly vs. yearly withdrawals.
Potential Flaws with This Type of Analysis
As with any analysis, it is important to point out what might be considered flaws in the assumptions. Pointing out these flaws is not intended to diminish the value the research done. No analysis or prediction can be perfect and being aware of the potential shortcomings may help you have more success applying the data.
The studies assume retirement length of 30 years is sufficient. Back in the 1990s, early retirement was more of a rarity and life expectancy wasn’t quite as long as today. With the Financial Independence Retire Early (FIRE) movement in recent years, more and more people are trying to leave their corporate jobs as soon as possible. This means that their money has to last them much longer than 30 years, in many cases 50 years or more. For an early retiree, assuming they could withdraw 4% is potentially dangerous to their long term outlook. Bengen showed that using withdrawal rates of 3% there were no cases between 1926 and 1976 where the retirement funds did not last at least 50 years. So in the case of people trying to retire very early, a withdrawal rate of less than 4%, and even as low as 3%, is probably a good idea.
As with any financial analysis, past performance is not necessarily indicative of future returns. The 4% rule is based on historical data. There is no guarantee that there won’t be a worse environment in the future. However, no other predictive analysis will be immune to assumptions such as these. Also, the data does include the bear markets of 1929-1931, 1937-1941, and 1973-1974 which were all terrible times for the financial markets and the 4% withdrawal rate still survived through these times.
Within the data, there is a very broad range of outcomes. In some cases, the retirement funds were just surviving after 30 years. In other cases, after 50 years, the accounts were still going strong and still growing. Depending on your personal situation, you may or may not want to leave an inheritance behind. Additionally, choosing a set percentage withdrawal without adjusting it based on market conditions could lead to either an overly aggressive or overly conservative retirement.
Advantages of 4% Rule Analysis and Philosophy
The intent of the 4% rule is to have an easy approach to withdrawing in retirement. Once you choose your initial withdrawal amount, simply adjust for inflation (or deflation) and rebalance your portfolio each year. One major advantage of this philosophy is that it takes the emotion completely out of it. It saves you from being too bullish and withdrawing too much when the market is up and also from being fearful when the market is down.
Even if you don’t intend to use a “set it and forget it” approach in retirement, using the reverse of the 4% rule or the “multiply by 25 rule” can provide a nice estimate for how much money you will need in order to retire. Using your expected retirement spending for one year, multiply by 25. This will give you the amount you need such that a 4% withdrawal covers your yearly spending. Remember that if you are planning an early retirement, you may want to use less than 4% as your yearly withdrawal, in which case you would need to multiply your yearly spending by 28 (for 3.5%) or 33 (for 3%).4
Even though the research that was done assumed there were no adjustments made to the withdrawal amount (other than inflation), that doesn't mean you have to go 30 years without making any adjustments. Additionally, since 4% is a relatively small number compared to your total investment portfolio, if your portfolio is not going to last as long as you need, you will have plenty of warning (many years) where you can make the realization that you are off track At this point you could make small adjustments that have a big effect over the long run.6
Updated Analysis from thepoorswiss.com
In January 2020, an article was posted by thepoorswiss.com5 updating the analysis on the topic. Improvements to the analysis include the fact that it includes data from 1871 until 2019 and that retirement durations of up to 50 years were analyzed. This analysis further supports the previous studies in that it shows that over any 30 year period within the dates referenced, 4% withdrawal rates at 50% to 75% stock allocation have a success rate nearing 100%.
For early retirees, the analysis is a huge improvement because it includes retirement periods of up to 50 years. For retirement periods of 50 years and more, withdrawal rates of 4% were not completely safe anymore (~90% success rate) and a lower withdrawal such as 3.5% gives early retirees a much better chance.
For comparison sake, thepoorswiss analysis used data from Early Retirement Now (footnote), which indicates S&P 500 for stocks and the 10 year treasury bonds though it’s not entirely clear where the data from 1871 to 1926 for stocks came from. The analysis assumed there was no rebalancing, but the monthly withdrawals were proportional to the allocation at the time.
Conclusion
As a rule of thumb, data supports that the safe withdrawal rate for retirement periods of 30 years or less is around 4%. For longer retirement periods, withdrawal rates of 3% to 3.5% are much safer and nearly guarantee success of the portfolio outliving the person.
There isn’t a one-size-fits-all approach to retirement that will fit everyone's needs. Each person’s situation contains a set of unique circumstances that will require individual customization to their retirement approach. The 4% rule can be a great rule of thumb and can help in determining what your retirement income will be and how much you may need for retirement. Your own spending needs, retirement timeline, and risk tolerance will drive the individual decisions you make regarding your retirement. You will need to weigh the benefits of a higher retirement income vs. the risk of running out of money and no amount of analysis can do that part for you. As stated by Trinity Study authors, “In the final analysis the choice of a portfolio withdrawal rate, within a reasonable range, requires very personal choices that perhaps are beyond the scope of financial analysis.” The best thing you can do is educate yourself with as much data as you can, be honest with yourself about your spending and lifestyle, and be confident in the decisions you make. Happy investing and retirement planning!
Disclaimer: This article is intended to be a general resource only and is not intended to be nor does it constitute legal or professional advice. Any recommendations are based on personal, not professional, opinion only.
Footnotes and References:
(1) Bengen, W (1994, Oct). Determining Withdrawal Rates Using Historical Data. http://www.retailinvestor.org/pdf/Bengen1.pdf
(2) Trinity Study https://www.aaii.com/files/pdf/6794_retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable.pdf
(3) Bengen determined the number to be slightly higher than 4% and Trinity Study determined it to be slightly lower than 4%.
(4) An early retiree would also need to consider strategies for withdrawing from age restricted accounts to avoid penalties.
(5) The Poor Swiss (2020, Jan 18). Updated Trinity Study for 2020 - More Withdrawal Rates! Retrieved from https://thepoorswiss.com/updated-trinity-study/
(6) Fantastic podcast from BiggerPockets Money with Michael Kitces discussing the details and some misconceptions of the 4% rule