Most of us know that we need to be socking away a lot of dollars for retirement, and many of us are doing so. It's hard to know how much money we'll need, though, which makes it hard to know how much we have to save and accumulate. We don't want to save too little and run out of money -- but we'd rather not save more than we'll need, too.

There's a simple but imprecise tool that can help with your retirement income planning -- the "4% rule." Take some time to learn what it is, why it's problematic, and how it can still be useful.

illustration of the number 4 percent with a faceless figure leaning against it

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Meet the 4% rule

The 4% rule was introduced in 1994 by financial advisor Bill Bengen and was later made famous in a study by several professors at Trinity University. The rule suggests that you can withdraw 4% of your nest egg in your first year of retirement, adjusting future withdrawals for inflation, in order to make your money last through retirement. It assumes a portfolio that's 60% in stocks and 40% in bonds, and it's designed to make your money last through 30 years.

Here's an example of how it works: Imagine that you've saved $600,000 by the time you retire. In your first year of retirement, you can withdraw 4%, or $24,000. In year two, you'll need to adjust that rate by inflation. Let's say that inflation over the past year was at its long-term historic rate of 3%. You'll now multiply your $24,000 withdrawal by 1.03 and you'll get your second year's withdrawal amount: $24,720. The following year, if inflation is still around 3%, you'll multiply that by 1.03 and get your next withdrawal amount, $25,462.

It's pretty simple, right? It is, but it's also flawed.

graph on a chalkboard of a retirement plan, with three stacks of coins getting bigger from year one to year two and then three

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Problem 1: The 4% rule isn't guaranteed to make your money last.

First off, following the rule won't guarantee that your money will last as long as you do. Researchers at T. Rowe Price ran some simulations and found that a portfolio that's 60% in stocks and 40% in bonds would have an 87% chance of lasting for 30 years with a 4% initial withdrawal rate. That's pretty good, but a 13% failure rate is still significant. The same simulation found only a 79% success rate over a 35-year period. It's worth thinking in terms of 35 years instead of 30, as many people retire earlier than expected and many people live extra-long lives. Retire at 60 and die at 95, and you're looking at a 35-year retirement. It's not necessarily what most people will have, but it's very possible for many people.

Problem 2: Your stock-bond allocation will make a big difference in your results.

Meanwhile, remember that the rule as originally designed was split 60-40 between stocks and bonds. Well, that might not be the allocation you have or want -- or you might plan to be shifting your allocation over time. If so, the 4% rule won't exactly fit.

The more heavily weighted with stocks your nest egg is, the more rapidly it will be able to grow -- but it will also be more exposed to stock market corrections. Skew your portfolio more toward bonds and it may be more stable, but it probably won't grow as briskly. Each of us will have to settle on the mix that seem best for us, adjusting it over time.

It's worth noting, too, that we seem to be at the beginning of a period of rising interest rates. As rates rise, bond investments might lose value. The 4% rule was created more than 20 years ago, when interest rates were higher. Meanwhile, today's lower rates mean that the fixed-income portion of people's portfolios won't produce as much income as it would have in the past and will be less able to replenish funds withdrawn each year. Each span of 20 to 30 years is different. 

Problem 3: Market volatility will affect your results

Finally, remember that the overall market is volatile. You might have a nest egg of $500,000 in the year before you retire, but what if the market suddenly crashes by 10% or 20%? Or what if it crashes and stays depressed soon after you retire? You might have withdrawn $24,000 in year one, but if you take out $24,720 in year two from a nest egg that has shrunk to $500,000, you'll be withdrawing 5%, not 4%, which might shorten the life of your portfolio. Conversely, if the market soars in your retirement's early years, you might be short-changing yourself by taking out a smaller percentage than you could.

on a chalkboard, retirement income 101 is written

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Is there any use for the 4% rule?

So should you just disregard the 4% rule, then? Well, no -- not necessarily. The rule does make it easy to estimate how much you can safely withdraw from your retirement nest egg each year, while making that nest egg last a long time. Used as a rough guide, it can help you set expectations.

The 4% rule can also help you determine how much you'll need to accumulate in the first place. You first have to know how much annual income you'll want in retirement, though. Let's say, for example, that you'd like total income of $60,000, and you expect to collect $25,000 from Social Security. That leaves $35,000 in income that you'll need to generate on your own. It would be your first year's withdrawal. So if you assume that $35,000 is 4% of your nest egg, then you can multiply $35,000 by 25 in order to arrive at how big the nest egg will need to be: $875,000. (Why 25? Because one divided by 0.04 is 25.) See? Handy.

So what should you do with the 4% rule?

Yes, the 4% rules is problematic, but you needn't throw it out entirely. You can use it as a rough guide and you can tweak it to make it serve you better. You can also tap the expertise of advisors to develop your own plan. Here are some strategies to consider:

  • To play it safe (if you can afford to do so), consider withdrawing less than 4% annually. You might also work a few years longer than you had planned to, in order to shorten your retirement and plump up your nest egg a bit more. (You can also take steps to increase your income in retirement.) The more conservative you are, the smaller the likelihood that you'll run out of money, but you're also more likely to die with a large unspent balance -- and perhaps have fewer years of retirement to enjoy.

  • If you're retiring late and expect your retirement to be shorter than most, you might withdraw more than 4% annually -- maybe 4.5% or 5%.

  • Take market conditions into consideration. In a year when the market drops, withdraw less money. In a year when it booms, you might take a little more. Some advisors suggest not adjusting your withdrawal for inflation in any year when the market falls or your portfolio shrinks.

  • Another way to lengthen the life of your nest egg is to never adjust your withdrawals for inflation, on the assumption that you'll spend less each year over time, growing less active as you age. So if your initial withdrawal is $24,000, it will stay at $24,000. You may or may not be able to pull this off, as inflation will be working against you, and while many expenses shrink as we age, healthcare expenses often increase.

  • If you find that you're withdrawing more than your expenses require, cut back on your withdrawals.

  • Look into immediate (not variable or indexed) annuities. They can provide guaranteed income for life and remove a lot of uncertainty and worry.

Be sure to reevaluate your withdrawals and the size of your nest egg as you progress through retirement – especially in the early years. You want to remain on course to having your money outlast you. Don't be afraid to seek professional advice, either – ideally, from a fee-only advisor over one with possible conflicts of interest. Social Security won't be enough for most of us, so saving and planning, perhaps while using the 4% rule, can help us reach our retirement goals.