Loading the player...

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.

RELATED TERMS
  1. Withdrawal Plan

    A withdrawal plan is a financial plan that allows a shareholder ...
  2. Hardship Withdrawal

    Hardship withdrawal is an emergency withdrawal from a retirement ...
  3. Early Withdrawal

    Early withdrawal is either removal of funds from a fixed-term ...
  4. Withdrawal

    A withdrawal is removal of funds from an account, plan, pension ...
  5. Rule Of 70

    The rule of 70 is a means of estimating the number of years it ...
  6. Fixed Amortization Method

    The fixed amortization method spreads retirees’ account balances ...
Related Articles
  1. Financial Advisor

    The 4% Withdrawal Rule: One Size Fits All?

    The 4% rule for retirement withdrawals has been a staple in financial planning for over 20 years, but no rule of thumb or approach is one size fits all.
  2. Financial Advisor

    4 Mistakes to Avoid with Your Retirement Plan

    The retirement landscape is changing. Here are four things retirees today need to be wary — and aware — of when it comes to their investments.
  3. Retirement

    Why The 4% Rule No Longer Works For Retirees

    Researchers have proven that the 4 % rule, which stated that retirees can withdraw 4% of the value of a portfolio each year without depleting the principal for 30 years, is not a realistic withdrawal ...
  4. Retirement

    Should Retirees Be in the Stock Market Now?

    The question of whether retirees should be in the stock market is complex. A look at the market in 2016 can help retirees understand portfolio options.
  5. Retirement

    Why The 4% Retirement Rule Is No Longer Safe

    Some big-name investment firms believe the 4% rule for annual withdrawals is still valid but most advocate greater flexibility as stock markets gyrate.
  6. Financial Advisor

    3 Ways Retirees Can Generate Income from Investments

    It's not enough to have savings; those investments have to generate income to last through retirement. Here's how.
  7. Retirement

    Should Retired People Invest in Stocks?

    Your financial situation and personal risk tolerance will dictate the amount of stock you want in your retirement portfolio. Get professional advice.
  8. Retirement

    How You Can Plan for Sequential Risk in Retirement

    Trying to plan your retirement date around future market forecasts can be futile.
  9. Retirement

    4 Books Every Retiree Should Read

    Learn more about the current financial situations retirees are facing and discover four books that every prospective and current retiree must read.
  10. Retirement

    The Top 3 Retiree Worries (And What To Do About Them)

    Discover the most common problems and concerns retirees face, and what they can do to solve them.
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  3. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  4. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  5. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  6. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
Trading Center