Here's What's Wrong With the 4% Rule

What You Need to Know

The 4% rule seems like a simple solution for retirement spending, but there are pitfalls.
The best approach is one that adjusts for actual market returns and real-life inflation rates.
For investors who prefer a formulaic approach, a better alternative to the 4% rule is to use the IRS’ RMD table.

Clients save for retirement over the course of their working careers. 

While retirement income planning can be complicated given the variety of available options, it’s typically easy to advise clients about how much they should be saving. Most clients should be advised to contribute the maximum amount they can afford to tax-preferred retirement accounts. 

The advisory picture becomes much more complex when it comes time to start drawing from those accounts. Once required minimum distributions are satisfied, clients often wonder how much they can safely withdraw to minimize the risk of running out of money during retirement. 

The “4% rule” is an often-cited strategy. Most retirees who rely primarily on retirement accounts for income during retirement will have difficulty adhering strictly to the rule’s assumptions. Although many clients like the formulaic approach of the 4% rule, it’s critical that advisors explain the fine print — and the risks associated with adhering strictly to the 4% rule during retirement.

Understanding the 4% Rule

The premise behind the 4% rule is simple. During the first year of retirement, clients withdraw 4% of their retirement account balance. For 30 years thereafter, that withdrawal rate is then adjusted by the rate of inflation as measured by the Consumer Price Index.

William Bengen, a financial advisor, published a paper in 1994 outlining the benefits of the 4% rule. His results were based on a study of stock and bond returns over a 50-year period, from 1926 to 1976, and a portfolio that consisted of 60% stocks and 40% bonds. Basically, the portfolio he used was designed to track the S&P 500.

The primary appeal of the 4% rule is that a client doesn’t have to engage in complex evaluations year after year during retirement. 

Potential Pitfalls

There are, of course, many pitfalls that clients should understand. First of all, the 4% rule is based on a 30-year retirement. Depending on the client’s age and life expectancy, a 30-year planning horizon may not be warranted.