You have spent 40 years saving for retirement, now what comes next? One of the biggest challenges of planning for retirement is figuring out how much you can withdraw from your portfolio during retirement without running out of money. Retirement income planning requires careful preparation and budgeting.
In 1994, William Bengen published a paper that answered this very question which has become a popular retirement income planning guideline.1 The 4% rule calculates withdrawal rates based on asset allocation and historical return data to guide spending withdrawals. It suggests that you live off 4% of your total investments during the first year of retirement and inflation adjust every subsequent year.
But does this rule hold up? Is the 4% rule a good strategy for you as you plan for living in retirement? Let's dive into this rule a little deeper and consider whether it's right for you.
What Is the 4% Rule?
The 4% rule is a guideline for managing your retirement income and suggests withdrawing up to 4% of your savings in the 1st year year of retirement and inflation adjust in subsequent years. For example, if you have $1,000,000 saved for retirement, you will withdraw $40,000 the first year.
The idea behind this rule is that it's easy to calculate and provides a benchmark for how much you should spend in retirement. The goal of retirement income planning is to make your money a lifetime and the 4% rule is designed to help retirees do exactly that.
The main challenge for retirees is that you can’t predict the future performance of markets. The good news is that the 4% rule has already factored in the downside risk of sequence of returns.2
The 4% rule is calculated by considering both historical returns on investments and potential market corrections. It also considers the average life expectancy of retirees. In 1990, when the rule was established, the average American man was expected to live 15 years after age 65, and the average woman just under 20 years. Using the 4% rule, retirees could expect to have about 35 years of living expenses.
So, the question remains: Does the famed 4% rule hold up today? Let's take a look.
Does the 4% Rule Hold Up Today?
Because the 4% rule is such a popular strategy, it's fair to wonder whether or not it's still relevant today. The short answer: maybe. Every retirement is different, so it's impossible to have one “rule” that works for everyone. While the 4% rule offers good insight into retirement income planning, it's more helpful to look at it as a guideline than a rule.3 It should be used as a starting point—and a basic guideline. It turns out that the most challenging period for retirees was not down markets but periods of high inflation because of loss of purchasing power.4
Today's retirees face so many factors that everyone can't subscribe to a concrete “rule,” even if it is popular. I think you can do better by finding your personalized spending rate. When planning out your retirement income, some things to consider include your investments, expenses, health, longevity, and goals. Everyone's expenses will look a little different in retirement, depending on where you live, how much money you have saved for retirement, your health care expenses, your hobbies, and whether you work part-time.
Your Investment Portfolio
The 4% rule does not include taxes or investment fees and these expenses will decrease the amount you can safely withdraw. According to Prudential, the 4% rule assumes that “you have about 60% of your investments in equities and 40% in fixed income assets,” and it's based on a tax-deferred portfolio like a traditional IRA or 401(k) and “assumes that you'll owe tax on withdrawals.” If you're spending from a Roth, where withdrawals aren't taxed if you meet essential criteria, “your calculations may be different.”5
Your Healthcare Expenses
It's no surprise that healthcare costs have gotten more expensive since the 4% rule was established in the 1990s. Today, the average 65-year-old couple can expect to spend over $300,000 on doctor's appointments and medical bills in retirement. Healthcare expenses are a significant part of your retirement income planning.6
Your Life Expectancy
In addition to having increased healthcare expenses, today's retirees live longer than they did 30 years ago. The average life expectancy in 1990 was 75.19 years; in 2022, it was 79.05 years.7
As you can see, many factors go into your retirement income planning, and properly preparing for retirement requires much more consideration than just sticking to a blanket guideline like the 4% rule. Every retirement is going to look a bit different.
- Determining Withdrawal Rates Using Historical Data— William Bengen was published in the Journal of Financial Planning