In the early 1990s, William Bengen, having just sold off his family's soda bottling business, moved to southern California to open a financial planning service. With a degree from MIT and a background in aeronautics and astronautics, he was a fool for numbers. So when his clients started asking how much of their nest egg they could draw down every year, he started doing the math.
Using historical data about market behavior -- especially the three largest bear markets in history -- Bengen coined what became known as the "4% Retirement Rule" in 1994. His research showed that:
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.
I have long advocated using the 4% rule to give you a ballpark estimate for how much annual income your nest egg can provide in retirement. For instance, if you have $500,000 in retirement accounts, then you can safely withdraw $20,000 per year.
But like any type of financial rule that we try to apply to everyone, the 4% rule has some shortcomings that investors need to be aware of.
What happens to the 4% rule if there's a massive downturn?
Nassim Taleb, author of the best-selling books The Black Swan and Antifragile, has long argued that the biggest problem with any type of predictive model is the use of previous "worst-case scenarios" to measure viability.
For instance, the designers of Japan's Fukushima Nuclear Power Plant made it able to withstand a "1,000-year earthquake" -- slightly stronger the worst ever recorded in the region. But the magnitude 9.0 quake experienced in March of 2011 was above this threshold.
We don't appreciate that every "worst-case scenario" in history was unimaginable before it happened. The same will be true in the future.
In his analysis, Bengen included the three largest stock dips, at the time (1929-1931; 1932-1941; 1973-1974) and concluded that retirees could safely keep 50% of their money in stocks and 50% in bonds. But what if there were a massive downturn? Surely, bonds provide a level of safety. But let's consider if stocks lost 50% of their value in someone's first year of retirement, and we assume bond returns of 10% -- the low end of the historical norm for such downturns.
Our investor who started with $500,000 would end their first year of retirement with $384,000. If she withdrew an equal (inflation-adjusted) amount in year two, then that would equate to a 5.4% withdrawal. That's a lot of money that will never have the chance to compound.
That's why, in the event of a severe downturn, retirees should start drawing down less of the nest egg, if possible, to preserve the amount of capital that will still be there when the market returns. Negative returns in the early years of retirement can make following the 4% rule to a tee very dangerous.
What happens to the 4% rule if inflation is high?
Here's another tricky aspect of the 4% rule: It automatically assumes that a retiree will take out an equivalent, inflation-adjusted amount every year of retirement. Typically, with inflation hovering between 2% and 4%, this isn't a big deal.
But when Bengen looked back in 2012 to comment on his 4% rule, he noticed something odd. A retiree who quit work in 1969 was able to preserve his capital entirely for the first 20 years of retirement, but then saw his balance disintegrate and disappear entirely by 1997. What's odd is that stock returns were generally good during this period. (It's worth mentioning that Bengen's hypothetical retiree was withdrawing 4.5% per year, as that was his new standard by then.)
The culprit, it turns out, was the rampant inflation of the late 1970s and early 1980s. While the market's returns were above average, inflation levels muted them significantly. For instance, from January 1980 to December 1981, the S&P 500 returned 26%, but inflation jumped roughly 27% over the same time frame. Thus real returnswere actually negative.
That has the same effect on the portfolio as poor investing returns. The earlier high inflation hits you in retirement, the more important it is to lower your withdrawals.
What's the money for, anyway?
Obviously, the two examples above represent extreme circumstance that probably won't affect most people reading this article. However, there's a third criticism to be aware of -- and it's much more personal than the first two.
What is your nest egg for, anyway? If you want to pass on a significant portion of your wealth to family, friends, or various causes, then the 4% rule -- notwithstanding the extreme events above -- is a great way to preserve and grow wealth in retirement. That will leave you with a lot to offer when you pass away.
But if you view your nest egg as your ticket to enjoy all the luxuries that life has to offer, then consider whether you want to leave money on the table when you pass away. If you want to splurge in retirement, then the smartest way to do so is ease into it, because withdrawals and returns in the early years of retirement have an outsize impact. Go easy for the first few years, and later on you'll be able to increase your withdrawals and be more financially secure.
All things considered, the 4% rule is still a great guidepost for retirees. The key is not following it too rigidly and understanding that you have the freedom to adjust your strategy when the situation calls for it.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.