Is the 4% Rule of Retirement Still Good Advice?

Many retirement experts have advised people to follow the "4% rule" of retirement, which basically says that you should withdraw 4% of the value of your retirement savings in your first retired year, and then adjust this amount annually to keep pace with inflation. As the theory goes, this strategy will give your money an excellent chance of lasting throughout your retirement.

Source: 401kcalculator.org via flickr.

However, some experts are now saying that the 4% rule is outdated. We asked three of our retirement analysts whether the 4% rule is still good advice or not, and here's what they had to say.

Leo Sun: In my opinion, the classic 4% rule is designed for people who ignore the stock and bond markets. On one hand, ignorance is bliss; on the other hand, retirees could prematurely deplete their portfolios with flat-rate withdrawals if they are oblivious to dramatic market shifts.

If a person retired in 2007, then withdrew 4% annually through the nadir of the financial crisis, the size of the retirement portfolio would have been reduced disproportionately in comparison to the subsequent years of recovery. But if a person starts withdrawing 4% at the apex of a bull market, the opposite happens -- a disproportionate amount of unused money could remain at the end of the retiree's life. Moreover, flat-rate 4% annual withdrawals might not be enough to cover age-related health expenses.

To solve these problems, some investment managers employ computer algorithms that factor in market performance, remaining balance, and the overall term of the portfolio to calculate "dynamically changing" annual withdrawals for retirees. Others can help retirees set up income-generating portfolios -- filled with low-beta dividend stocks and higher-yielding bonds -- which can generate reliable annual income without depleting the principal.

Matt Frankel: Like Leo, I think retirement spending should be adjusted, but I'd like to expand on his thoughts a bit. Specifically, retirement withdrawals should be adjusted for market performance and your life circumstances.

Basically, by withdrawing 4% of your initial balance in your first year of retirement, then adjusting for inflation in subsequent years, you are assuming that your expenses will be the same each year. And a steady withdrawal rate doesn't account for market performance, as well.

So, instead of the 4% withdrawal rule, I urge retirees to be flexible in their spending. If you're working part time, or you don't have a lot of extra expenses like vacations and medical bills, or you simply don't need 4% of your portfolio to live on, withdraw a little bit less. On the other hand, if you have an "expensive year" where you, for instance, plan to take a once-in-a-lifetime vacation, it's OK to adjust your spending upward.

The same philosophy applies to market performance. If the market has a bad year and your portfolio is down, it may be a good idea to tighten your belt and cut spending, giving your portfolio a better opportunity to recover when the market does. And if your investments have a particularly good year, there's nothing wrong with treating yourself or your loved ones a little bit.

The bottom line is that a better strategy than the "4% rule" is to adjust your retirement withdrawals to match your life and your investment performance.

Dan Caplinger: I think the 4% rule is still solid advice for those preparing for retirement, as long as you understand its limitations. When you flip the rule on its head, it provides a useful milestone for assessing your retirement savings goals: To be ready for 4% withdrawals, you'll want to accumulate 25 times whatever you'll want to withdraw in your first year of retirement. To build in an extra margin of safety, all you have to do is save more than that target amount.

The concern most people have with the 4% rule is that it's inflexible and has the potential to be disastrous if market conditions get bad enough. Yet it's also important to understand that the research underlying the 4% rule has taken some pretty bad market environments into account.

Those who are more aggressive have long argued that a higher withdrawal rate would usually be safe, and that the 4% rule is too conservative. Others point to hypothetical worst-case scenarios, and argue that lower rates are necessary for complete safety. By that measure, the 4% rule does a good job of providing a middle-of-the-road solution for those who are comfortable with the limited risk of the black-swan event necessary to cause the strategy to fail.