Many financial experts rely on the 4% rule to guide their retirement savings advice. And while the rule certainly has merit, it's not without flaws. Here, we'll take a deep dive into the 4% rule and review its strengths and weaknesses.
How the 4% rule works
Developed by William Bengen in the mid-1990s, the 4% rule states that if you withdraw 4% of your savings during your first year of retirement, and then adjust withdrawals for inflation going forward, there's a strong chance your savings will last 30 years. As an example, if you were to kick off retirement with a savings balance of $600,000, you'd withdraw $24,000 your first year and then adjust future withdrawals upward to keep pace with inflation.
Given that Americans are living longer these days, planning for a 30-year retirement is an unquestionably smart move. The only problem is that the 4% rule has some inherent defects that, if followed, could dash that 30-year dream.
Major problems with the 4% rule
The 4% rule is based on a number of assumptions, the most potentially fatal of which is the idea that the typical retiree's portfolio will consist of 40% to 50% bonds, and that those bonds will pay enough interest to reasonably keep up with inflation. But as anyone who's currently invested in bonds will tell you, today's interest rates are nothing to write home about, and they're considerably lower than what rates looked like back when the rule was established. If you're looking at portfolio that's 50% bonds (which isn't unreasonable, as we're often advised to shift toward bonds as retirement nears), but those bonds are only capable of producing a fraction of their once-anticipated income, an annual withdrawal rate of 4% could be downright infeasible.
Another problem with the 4% rule is that it assumes a rather even market performance over time. But what happens if a downturn hits just before you're set to retire? If your investments take a dive, you'll risk depleting your savings sooner than expected if you stick to a 4% withdrawal rate.
Then there's the opposite scenario: What if the market exceeds expectations during your withdrawal period? You could end up shortchanged if you limit yourself to a 4% withdrawal rate, and while that's far better than running out of savings, it also means losing out on a chance to enjoy your money while you're still alive.
Clearly, the 4% rule isn't perfect, but it does have a strong history of success. In fact, the 4% rule can serve as a solid starting point for establishing a savings target and seeing whether you're on track to get there.
Applying the 4% rule
The value of the 4% rule is that it serves as a benchmark for savings -- plus, it's pretty easy to use. Let's say you expect to need $4,000 a month in retirement income, $1,500 of which will come from Social Security. That leaves you with a $2,500-a-month gap, or $30,000 a year that will need to come from independent savings. Multiply that amount by 25, and you'll arrive at a $750,000 savings target.
Once you establish your own target, you can use this helpful calculator to see whether your savings are likely to amount to the total you'll need. Or, you can use common sense to see whether you're on track. If, for example, you're 50 years old and have just $50,000 saved for retirement, you don't need a calculator to tell you that without a major ramp-up in savings, you're not going to hit a $750,000 goal. Similarly, if you're 40 years old but have not yet saved a dime, you'll need to get moving if you want a shot at a secure retirement.
Make no mistake about it: The 4% rule is by no means perfect, and it's not necessarily the right strategy for taking withdrawals in retirement. But what it can do is help you arrive at a rough savings target that you can work toward while you're still earning a paycheck. Or, to put it another way, the 4% rule can serve as a major wakeup call for the countless Americans who are behind on retirement savings. If you're one of them, with any luck, the 4% rule might be just the thing that prompts you to change your ways.