If you withdraw the wrong amount from your investment portfolio in retirement, there will be major consequences to your lifestyle. Withdraw too much, and you may run out of money during your lifetime. Withdraw too little, and you may end up looking back on your life with regret wishing you had enjoyed yourself more.
If you Google search “how much can I withdraw from my investment portfolio,” the majority of the results reference “the 4% rule.”
The 4% rule is the most common rule of thumb you’ll hear from financial professionals when discussing portfolio withdrawals. I’ll admit - I often use it to make ballpark retirement planning estimates when I don’t have financial planning software available.
However, just like most rules of thumb, it’s not going to be appropriate for everyone. But before I get into the problems with blindly following the 4% rule, let’s define what it is.
The 4% Rule in a Nutshell
Simply put, the 4% rule suggests a new retiree can safely withdraw 4% of their initial portfolio balance the first year in retirement and increase it for inflation every year after that. For example, a retiree who starts with $1 million would withdraw $40,000 the first year of his or her retirement. If inflation is 3% over that year, they would withdraw $41,200 the next year ($40,000 x 1.03 = $41,200).
Where it Came From
This rule of thumb originated from research performed by William Bengen. He tested every 30-year period since 1926 using a portfolio that was invested in 50% stocks (S&P 500 Index) and 50% bonds (intermediate-term government bonds) to determine how much a retiree could safely withdraw from their investment portfolio. He found that - even in the worst 30-year period - a retiree could have withdrawn 4.15% of their starting account balance and increased this for inflation each year without running out of money1.
This was groundbreaking research, and it had a major influence on the financial advisory community. Over time, the 4% rule has become a common assumption used in basic retirement planning.
Problems with the 4% Rule
To Bengen’s credit, his research advanced our understanding of safe portfolio withdrawal rates tremendously. However, that doesn’t mean it is an appropriate recommendation for every retiree (and I’m confident he would say the same thing).
Here are a few reasons you may not be able to rely on the 4% rule for your retirement plan:
It Doesn’t Account for Your Specific Time Horizon
Bengen’s research is based on the assumption that the retiree has a 30-year time horizon. Depending on your retirement age and life expectancy, your time horizon may be materially shorter or longer, which may reduce or increase the amount you can safely withdraw from your investment portfolio.
When building retirement plans, I’ve found that time horizons longer than 30 years slightly decrease the amount you can safely withdraw from a portfolio. When going from a 30 to a 40-year time horizon, I usually see about a .5% drop in the safe withdrawal percentage.
The opposite is also true. If your time horizon gets shorter, the safe withdrawal percentage is higher2.
For example, if you’re single and retiring at age 70, the IRS single life expectancy table suggests you have another 17 years to live. With a 17-year time horizon, you could start out withdrawing much more than 4% of your portfolio balance. Following the 4% rule in this scenario would lead you to unnecessarily sacrificing your lifestyle.
It Doesn’t Account for Your Specific Asset Allocation
The investment portfolio used in Bengen’s original research assumed the retiree invested half of his portfolio in stocks and the other half in bonds. If your investment portfolio has a different ratio of stocks to bonds, your safe portfolio withdrawal percentage may be higher or lower.
If a higher percentage of your investment portfolio is invested in equity investments (stocks, real estate), you may be able to withdraw slightly more from your portfolio. The difference tends to be very small though because of the extra uncertainty around stock returns.
If your portfolio is primarily invested in fixed income investments (bonds, CD’s, money market funds), you are likely to run out of money if you follow the 4% rule because the expected return of an all-bond portfolio is so much lower.
It’s also worth noting that the portfolio used in Bengen’s initial research only included two types of investments (i.e. asset classes): large companies in the US stock market (represented by the S&P 500 Index) and intermediate-term government bonds. That is not a very diversified portfolio. Diversifying your portfolio across additional asset classes may allow for higher portfolio rates2.
In fact, in his later research, Bengen found that merely adding US small company stocks to an investment portfolio increased the safe withdrawal rate to 4.5%2. Adding international stocks, international bonds, and real estate into the mix adds additional diversification and may allow for even higher withdrawals - though it’s worth noting that this will likely be a marginal improvement because you reach diminishing returns fairly quickly when adding additional asset classes to a portfolio.
It Doesn’t Adjust Based On Market Returns
The 4% rule is a set-it-and-forget-it strategy. You start with your 4% withdrawal and increase it each year for inflation no matter what happens in the financial markets.
It makes a lot more sense to adapt to the investment returns you earn by adjusting your portfolio withdrawals. If returns are poor, common sense would suggest you cut back your spending and withdraw less from your investment portfolio. If returns are good, you can increase your spending and portfolio withdrawals to take advantage of your good fortune.
I recognize that you can’t drastically change your spending every year - some expenses are fixed, and everyone has a minimum level of income required to fund his or her lifestyle. But, if you start with a conservative withdrawal percentage, any spending cuts should be modest and almost everyone has some wiggle room in their budget to make minor spending cuts if necessary.
If you have a reasonably conservative financial planning approach that anticipates bad market returns - you are more likely to experience spending increases than spending cuts. I don’t know too many people who wouldn’t like to spend more (or gift more) if they had the opportunity.
It Creates the Possibility of Overspending and Underspending
Because it lacks a system for adjusting the initial portfolio withdrawal amount, the 4% rule opens you up to the possibility of overspending and underspending.
Remember, the 4% rule is based on historical US data. If we experience a 30 year period that is worse than anything we have experienced in the US up to this point, you could run out of money. Retirement researcher, Wade Pfau, tested the safe withdrawal rates in other countries and found that following the 4% rule would have caused a retiree to run out of money in many of them2. Admittedly, if your portfolio is invested in many asset classes and countries, there’s a low likelihood this will be a problem, but it is possible.
A bigger issue with the 4% rule is that it usually leads to underspending because it’s based on the worst-case scenario. In fact, when you look at the results of historical tests of the 4% rule, 96 percent of the time you end up with more money than you started with (sometimes substantially more)2.
Underspending and growing your wealth throughout retirement may not sound like a bad thing, but it represents money you could have enjoyed during your lifetime. Even if you’re not a spender and you like the idea of leaving a legacy, it’s a lot more fulfilling to give while you’re alive so you can see the positive impact you’re having on the world. As the saying goes, “it’s better to give with a warm hand than with a cold one.”
What Should You Do?
If you’re approaching retirement, planning to blindly follow the 4% withdrawal rule is a bad idea.
When it comes to your retirement, the stakes are too high to rely on rules of thumb.
If you want to maximize your retirement lifestyle while minimizing the likelihood of running out of money, your initial portfolio withdrawal must account for your specific time horizon and asset allocation. You must also have a process for adjusting your portfolio withdrawal based on the investment returns you earn during your retirement.
- Bengen, William P. 1994. “Determining Withdrawal Rates Using Historical Data.” Journal of Financial Planning 7 (4): 171-180
- How Much Can I Spend In Retirement? Wade Pfau, Ph.D., CFA