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What is the 'Four Percent Rule'

The 4 percent rule is a rule of thumb used to determine how much a retiree should withdraw from a retirement account each year. This rule seeks to provide a steady income stream to the retiree while also maintaining an account balance that keeps income flowing through retirement. Experts consider the 4 percent withdrawal rate safe, as the withdrawals will consist primarily of interest and dividends.

BREAKING DOWN 'Four Percent Rule'

The 4 percent rule helps financial planners and retirees set a portfolio's withdrawal rate. Life expectancy plays an important role in determining if this rate will be sustainable, as retirees who live longer need their portfolios to last longer, and medical costs and other expenses can increase as retirees age.

Origins of the 4 Percent Rule

The 4 percent rule was created using historical data on stock and bond returns over the 50-year period from 1926 to 1976. Before the early 1990s, experts generally considered 5 percent a safe amount for retirees to withdraw each year. Skeptical of whether this amount was sufficient, financial advisor William Bengen conducted an exhaustive study of historical returns in 1994, 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 percent annual withdrawal exhausted a retirement portfolio in less than 33 years.

Accounting for Inflation

While some retirees who adhere to the 4 percent rule keep their withdrawal rate constant, the rule allows retirees to increase the rate to keep pace with inflation. Possible ways to adjust for inflation include setting a flat annual increase of 2 percent per year, which is the Federal Reserve's target inflation rate, or adjusting withdrawals based on actual inflation rates. The former method provides steady and predictable increases, while the latter method more effectively matches income to cost-of-living changes.

When to Avoid the 4 Percent Rule

There are several scenarios where the 4 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 when 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 4 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 this reduces the principal, which directly impacts the compound interest that the retiree depends on for sustainability.

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