Given the possibility of severe market downturns in the future, how much of your retirement portfolio can you withdraw every year while still leaving enough to see you through life after work? The 4% rule is designed to answer this question.
The origins of the 4% rule
At one point, it was believed that the typical retiree could safely withdraw 5% of the original balance of their portfolio every year, adjusted upward for inflation, without fear of running out of money. Thus, if you saved $500,000 by the time you retired at the age of 65, then you could withdraw $20,000 the first year and then increase your withdrawal by roughly 3% each subsequent year to account for inflation.
But a groundbreaking paper published in 1994 proved this wrong. Using historical stock and bond market data to assess the impact of acute market downturns from 1926 to 1976, William Bengen found that a 5% withdrawal rate would, in many cases over the preceding decades, have depleted a person's retirement account prematurely.
After running through a number of scenarios, Bengen concluded instead that the safest withdrawal rate was 4%:
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. In no past case has it caused a portfolio to be exhausted before 33 years, and in most cases it will lead to portfolio lives of 50 years or longer.
It's worth pointing out that when Bengen says "in no past case," he's referring not only to the severe market downturn in 1973-1974, during which stocks dropped by 37%, but also to the entirety of the Great Depression, when the value of stocks dropped by 61% between 1929 and 1931 and by 33% from 1937 to 1941.
Applying the 4% rule
There are two ways people who are preparing for retirement can use this now widely accepted benchmark.
In the first case, if you're already on the eve of retiring, it tells you how much of your savings can be safely withdrawn each year while still allowing your portfolio to last for a minimum of 30 years -- namely, 4% of the original balance in the first year, followed by the same amount in later years adjusted upward by inflation.
Alternatively, if you still have time before reaching retirement, you can work backwards using the 4% rule to calculate how much you need to save in order to support a given lifestyle. To do so, simply take your desired income in retirement, less your anticipated Social Security benefits, and multiply the figure by 25.
For example, if you think you'll spend $50,000 a year in retirement above and beyond your projected Social Security benefits, then the 4% rule dictates that you'll need a $1.25 million balance in your retirement portfolio (25 times $50,000) by the time you leave the workforce.
At the end of the day, of course, there are no guarantees in life -- and that includes the 4% rule. That being said, given the stringent scenarios used to test it, I believe people can and should use it as a central guidepost to determine how much to save for, and spend in, retirement.
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.