If you are in or near retirement, one of your main concerns is how to survive financially without a paycheck. After factoring in social security and pensions, the balance of your spending needs have to come from your investment assets. How much can you withdraw from those assets and maintain your standard of living through retirement?
That is the question that William Bengen posed in a paper titled “Determining Withdrawal Rates Using Historical Data” which was published in the Journal of Financial Planning in October 1994. Mr. Bengen used historical data for stock and bond returns over 30 year periods and calculated that a 4% withdrawal rate would allow investment assets to last for the full 30 years. Since the publication of the paper, the “4% rule” has been the starting point for many retirement plans.
How Does the 4% Rule Work?
Many people do not realize that the 4% withdrawal rate only pertains to the first year of retirement. After the first year, the 4% amount is increased for inflation. For example, if you have a $1,000,000 investment portfolio, in year one, you can withdraw 4% of that amount, or $40,000. If inflation for the first year is 5%, in year two, you could withdraw $40,000 + 5%, or $42,000.
Mr. Bengen used a variety of stock and bond allocations in his analysis. He concluded that the stock allocation needed to be in the range of 50% to 75%. Any higher or lower would not allow your investments to last the full 30 years 100% of the time.
Will the 4% Rule Work for You?
The short answer is “maybe”. Using stock and bond return data from Ibbotson, S&P, Barclays and Bloomberg, and CPI inflation date from the Minneapolis Federal Reserve Bank, I recreated Mr. Bengen’s analysis from 1929 to 2023. I used a $1,000,000 starting investment balance and a 60% stock, 40% bond allocation. With a 4% withdrawal rate adjusted for inflation each year, every period had assets remaining at the end of 30 years. Below are some of the results for interesting periods in financial history:
| Total Inflation | Ending Assets | Stock Market Increase | Bond Market Increases | ||
|---|---|---|---|---|---|
| Highest Inflation Period | 1965-1994 | 383% | $1,000,3700 | 1,615% | 888% |
| Worst Stock Market Returns | 1929-1958 | 68% | $1,308,494 | 913% | 128% |
| Period including the Dot.com bubble and Great Financial Crisis | 1993-2022 | 102% | $5,137,312 | 1,485% | 288% |
*For illustration purposes only
Note the effect inflation has on the ending asset balance. Even though the 1965-1994 period had the highest stock and bond market returns shown, the ending asset balance was the lowest shown because inflation during the period was so high resulting in very high withdrawals. What would happen if the lowest stock market returns were paired with the highest inflation results? Your assets would run out in 17 years.
Issues to Consider Regarding the 4% Rule
- Many financial professionals think the rule should be modified. Some think a 3% withdrawal rate going forward is more appropriate. Others think a 5% rate is okay. Still others like the concept of a variable rate that rises and falls with market results. I think the 4% rate is still valid, but if you can get by on a smaller percentage, your odds of success increase.
- The 4% rule is not a guarantee that your assets will last in any situation. As noted above, high inflation with low stock market returns could deplete your funds well before the 30 year test period. It should be a starting point in your analysis.
- The returns over the 1929 to 2023 period cannot be relied on to repeat in the future. Since 1982, when bond yields peaked, interest rates declined and bonds generated large capital gains. While rates have increased recently, there is little chance that bond returns (interest plus capital gains) over the next 30 years will equal the last 30 years.
- What happens if your retirement lasts longer than 30 years (you live too long)? You need to monitor your investment balance and your spending and adjust accordingly.
- If you start retirement later than most (age 75), and have a 20 or 25 year retirement period, you can probably start at a higher withdrawal rate – 5% or 6%.
- The 4% rule does not take taxes or investment fees into account. Your income sources (social security, pension, investment returns) have to cover not only your living expenses, but also your taxes.
How to Use the 4% Rule in Planning for Retirement [requires some math]
If you are nearing retirement and want to know if you have enough investment assets to last for 30 years (using the 4% rule), follow these steps:
- Determine your spending needs for a typical year. This is the hardest step in planning. Remember to include vacations, gifts, health insurance, and unusual expenses.
- Go to the social security website (www.ssa.gov) and print out or view your social security report. You should see your social security benefit on the report. Have your spouse perform the same task and come up with your combined social security benefit.
- Subtract the annual social security benefit (and any annuities or pensions you will receive annually) from the annual expenses. The result will equal what you need to pay for from your investments.
- Take the result from #3 and divide it by 4% to get the investment balance you need to generate the amount to fully fund your expenses.
Example – You need $10,000 per month, or $120,000 per year for expenses. Your combined social security is $70,000. Therefore, you need $50,000 from your investments to fully fund your expenses. Dividing $50,000 by .04 = $1,250,000. This means that if your investment balance is at least $1,250,000, you can generate $50,000 in the first retirement year by taking 4% of the balance.
If you are 10 to 20 years from retirement and want to know how much you need to accumulate for retirement, follow these steps:
- Determine your spending needs for a typical year. This is the hardest step in planning. Remember to include vacations, gifts, health insurance, and unusual expenses.
- Once you have a spending estimate, you have to adjust it for future inflation. For a 2.5% inflation factor per year, multiply the spending estimate by the factors below for the numbers of years until retirement:
- For 10 years, 1.28
- For 10 years, 1.45
- For 20 years, 1.64
- Go to the social security website (www.ssa.gov) and print out or view your social security report. You should see your social security benefit on the report. Have your spouse perform the same task and come up with your combined social security benefit. You will need to use the inflation adjustment factors in #2 above to increase the social security benefit.
- Subtract the inflation adjusted annual social security benefit (and any annuities or pensions you will receive annually) from the inflation adjusted annual expenses. The result will equal what you need to pay for from your investments.
- Take the result from #4 and divide it by 4% to get the investment balance you need to generate the amount to fully fund your expenses.
Example – You need $10,000 per month, or $120,000 per year for expenses. You have 20 years until your expected retirement. Multiply the annual expenses, $120,000, by 1.64 to arrive at an expense amount of $196,800. Your combined social security is $70,000. Multiply that amount also by 1.64 to arrive at social security benefits of $114,800. Therefore, you need $82,000 ($196,800 – $114,800) from your investments to fully fund your expenses. Dividing $82,000 by .04 = $2,050,000. This means that in the next 20 years, you need to save an amount of at least $2,050,000 to generate $82,000 in the first retirement year.
Please call or email me if you would like to talk about your personal retirement plan.
Rick Zivi
Disclosures
The opinions expressed are those of NBZ Investment Advisors, LLC (“NBZ”). The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward looking statements cannot be guaranteed.
The information presented herein has been obtained from sources believed to be reliable, but NBZ does not warrant its completeness or accuracy. Figures, opinions and estimates reflect NBZ’s judgment on the date hereof and are subject to change at any time without notice. Projections are not guaranteed and may vary significantly.
The illustration shown in this blog is for illustrative purposes only and does not guarantee success or a certain level of performance. This material is not financial advice or an offer to sell any product.
NBZ is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about NBZ’s investment advisory services can be found in its Form ADV Part 2, which is available at nbzinvest.com or by calling (865) 584-1184. NBZ-24-01.
