5% Is the New 4% -- for Making Your Money Last Through Retirement

If you've done some reading about retirement planning, you've most likely run across the famous "4% rule," which suggests that if you want to make your retirement nest egg last for at least 30 years, you should withdraw 4% of it in your first year of retirement, and then adjust future withdrawals for inflation.

The rule is very appealing, because it's so easy to use. But 4% is not necessarily the right withdrawal rate for you. Indeed, the rule's creator, William Bengen, recently suggested that 5% is more appropriate.

Image source: Getty Images.

Here's a look at the rule and how you might go about figuring out the best withdrawal rate for yourself.

How the 4% rule works

However much money you start your retirement off with, the 4% rule tells you to withdraw 4% of it in your first retirement year. The table below gives you an idea of how much that would get you:

Data source: Author calculations.

So if you've socked away $300,000, you'd withdraw $12,000, which would give you about $1,000 per month. (This would be in addition to any income from Social Security, a pension, an annuity, or other income source.) If inflation in that first year is about 3%, matching the long-term average rate of inflation, you'd multiply your initial $12,000 withdrawal by 1.03, getting $12,360. That would be your withdrawal for year two. If inflation shoots up to 5% the next year, multiply $12,360 by 1.05, getting $12,978.

Unavoidably imperfect

That simplicity is appealing, but things are not quite as simple as they seem. When Bengen devised the rule, it was based on a portfolio that was divided between large-cap stocks and intermediate-term government bonds -- 50% in each. Others have recommended the rule for portfolios split 60%-40% between stocks and bonds. But if your own portfolio is rather different, such as 90% in stocks and 10% in bonds, that 4% may not be right for you. A portfolio that's bond-heavy may grow more slowly, and that could lead to faster depletion, while a portfolio that's stock-heavy might be more volatile.

Timing is another issue. What if the stock market crashes in your second year of retirement? Let's say that your nest egg was $300,000 and you took out $12,000 in year one. If that portfolio was suddenly worth only $200,000 the following year, a $12,000 (or $12,360) withdrawal would mean you were removing far more than 4% -- it would be 6% or 6.2%. Future withdrawals might keep drawing down that nest egg more quickly than the 4% rule was designed to do. Meanwhile, if the market surges in your retirement's early years, you might be taking out less than you could, short-changing yourself.

Bengen also expected annual rebalancing, which is something not every investor does -- or at least not that often: Selling and buying bonds and/or stocks as necessary to return to the original allocation mix.

Image source: Getty Images.

Mr. Bengen says... 5%

It's worth noting that after introducing the 4% rule in 1994, Bengen later revised it to 4.5%. And more recently, just a few months ago, Bengen offered some fresh thoughts on the 4% rule in an article in Financial Advisor magazine. He made clear, for example, that a wide range of withdrawal rates can be applicable, even some topping 10%, depending on factors such as inflation and stock market circumstances, and noted that his famous 4.5% recommendation is meant to make a retiree's money last through a worst-case scenario.

He laid out various assumptions for his latest withdrawal model, including tax-advantaged accounts, a portfolio of "30% U.S. large-cap stocks, 20% U.S. small-cap stocks and 50% intermediate-term U.S. government bonds," annual rebalancing, and a need for the money to last at least 30 years. He praised and drew upon the research of fellow financial advisor Michael Kitces, who tweaked the 4% rule, advising different courses of action based on how the market performed in the early years of retirement: Higher withdrawal rates were very possible when the stock market performed well early in retirement, and lower rates are advisable when the market grows slowly or sinks.

Bengen has applied much of Kitces' thinking, using the Shiller CAPE index (which reflects the cyclically adjusted price-earnings ratio for the S&P 500) and inflation data, to come up with his latest revision and recommendation for a generally safe withdrawal rate: 5%. In a late 2020 interview with Kitces, Bengen said: "It's not a great time to be taking high withdrawals now with the market so expensive, but it's not awful either because inflation is very low. I think somewhere in 4.75%, 5% [range] is probably going to be OK. We won't know for 30 years, so I can safely say that in an interview." Speaking to someone else, Bengen noted that he himself is using a 5% rate.

Here's the table from above, revised to reflect 5% withdrawals:

Data source: Author calculations.

What to do

Do your own reading and thinking on the matter of the best withdrawal strategy for you, and don't be ashamed to consult a professional or two, either -- a good financial advisor can help you make or save much more than they charge for their service, and they can give you more peace of mind that you have a reasonable plan, too. (You can look up fee-only advisors near you at NAPFA.org.)

Here are some strategies to consider:

• To be ultra-conservative, consider using a 4% or even 3.5% withdrawal rate, understanding that it may mean you end up leaving a lot of money to your heirs.
• To take on a modest level of risk, consider using a 4.5% or 5% rate.
• If the stock market is generally undervalued and expected to rise in the early years of your retirement, you might consider a higher withdrawal rate -- or increase your rate by more than inflation a few years into retirement, if the market has indeed grown briskly, significantly enlarging your nest egg.
• If you expect a relatively short retirement, perhaps because you're retiring late, you can boost that withdrawal rate, because you won't be looking for your money to last for 30 years.
• Some recommend tweaking your withdrawal rate from year to year not just based on inflation, but on market performance: If the market gained, say, 10%, you might withdraw 6% or more, but if it stalled or retracted, you might not increase your withdrawal rate at all.
• If your withdrawals turn out to be providing more income than you actually need, you might reduce your withdrawal rate. (Many retirees spend less and less each year during the middle years of retirement: The early years can feature travel and activity and later years may require increased healthcare spending.)
• When investing your money, the portion you want in stocks can do well in a low-fee broad-market index fund, such as the SPDR S&P 500 ETF (SPY 0.92%), Vanguard Total Stock Market ETF (VTI 0.98%), and Vanguard Total World Stock ETF (VT 0.93%). There are also index funds for bonds, such as the Vanguard Intermediate-Term Bond ETF (BIV 0.07%).
• Consider parking some or much of your stock money in dividend-paying stocks, as they can generate significant income without your having to shave off and sell any shares. That income can complement what you withdraw or can replace some of it.
• Another good strategy is spending some of your nest egg on one or more fixed annuities, as they offer nearly guaranteed regular income.

The more you learn about retirement issues, the more you'll be able to build a financially secure future for yourself. Don't leave your future to chance and wishful thinking, simply parking some money in a retirement account now and then. Develop a plan and stick with it -- and include a withdrawal strategy as part of that plan.