What is the 'Four Percent Rule'
The four percent rule is a rule of thumb used to determine the amount of funds to withdraw from a retirement account each year. This rule seeks to provide a steady stream of funds to the retiree, while also keeping an account balance that allows funds to be withdrawn for a number of years. The 4% rate is considered a "safe" rate, with the withdrawals consisting primarily of interest and dividends.
BREAKING DOWN 'Four Percent Rule'
The four percent rule helps financial planners and retirees set a portfolio's withdrawal rate. Life expectancy plays an important role in determining if this rate is going to be sustainable, as retirees who live longer need their portfolios to last a longer period of time, and medical costs and other expenses can increase as retirees age.
Origins of the Four Percent Rule
The four percent rule was created using historical data on stock and bond returns over the 50-year period from 1926 to 1976. Prior to the early 1990s, 5% was generally considered a safe amount for retirees to withdraw each year. Skeptical of whether this amount was sufficient, in 1994, financial advisor William Bengen conducted an exhaustive study of historical returns, focusing heavily on the severe market downturns of the 1930s and early 1970s. Bengen concluded that even during untenable markets, no historical case existed in which a 4% annual withdrawal exhausted a retirement portfolio in less than 33 years.
Accounting for Inflation
While some retirees who adhere to the four percent rule keep their withdrawal rate constant, the rule allows it to be increased to keep pace with inflation. Possible ways to adjust for inflation include setting a flat annual increase of 2% per year, which is the Federal Reserve's target inflation rate, or adjusting withdrawals based on actual current inflation rates. The former method provides steady and predictable increases, while the latter method more effectively matches current income to changes in cost of living.
When to Avoid the Four Percent Rule
Several scenarios exist in which the four percent rule might not work for a retiree. A person whose portfolio features higher-risk investments than typical index funds and bonds needs to be more conservative withdrawing money, particularly during the early years of retirement. A severe or protracted market downturn can erode the value of a high-risk investment vehicle much faster than it can a typical retirement portfolio.
Further, the four percent rule does not work unless a retiree sticks to it year in and year out. Violating the rule one year to splurge on a major purchase can have severe consequences down the road, as the principal base from which interest is compounded is reduced.