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4% Rule Misconceptions

A general rule of thumb in retirement planning says you can spend 4% of your starting portfolio value when you retire, then adjust that amount for inflation each year, and your money will last for at least 30 years. This rule is based on safe withdrawal rate research by Bill Bengen that was published in 1994. His research looked at historical market behaviors and determined that in every 30-year time period through history, this starting withdrawal rate would have made it through the 30 years without running out of money.

As with all rules of thumb, using the 4% rule isn’t a bad place to start to determine if you are on the right track for retirement. However, every situation is different, and many individual aspects of your retirement plan should be considered. There are also many misconceptions about the 4% rule, which I’ll try to clear up below.

The 4% rule means you will earn at least 4% on your portfolio yearly and can spend the earnings, leaving the principal intact. 

Even though interest rates have climbed above this level now, there’s no guarantee they will stay there and no guarantee your portfolio will earn 4% every year. The 4% rule assumes you spend from both the income and capital appreciation of the portfolio.

The 4% rule means you will spend every dollar in your lifetime.

On the opposite end of the spectrum, some worry that spending at this level will fully deplete their portfolio over their lifetime. However, the 4% rule says that this is the worst possible outcome out of many possible outcomes. In other words, most of the time, you will have a lot of money left at the end of your life, but in the worst-case scenario, your money still lasts 30 years.

You should never start with an initial withdrawal rate above 4%.

The actual safe initial withdrawal rate from the portfolio has varied between 4% and 10%, and the median is close to 6.5%. There is so much focus on the 4% number because we don’t know what the sequence of returns will be over the next 30 years, and 4% would have worked in any previous time period. 

My retirement age doesn’t impact the 4% rule.

The 4% rule is based on a 30-year retirement. If you have longevity in your family history and retire early, you could have a much longer retirement period, and 4% might be too high. Alternatively, if you retire later, you might have a shorter retirement period and be able to spend more.

My other retirement income sources don’t impact the 4% rule.

The 4% rule only looks at the withdrawals needed from your portfolio each year. It does not factor in social security income, pensions, or other income sources. 

Taxes and fees are already factored into the 4% rule.

Again, the 4% rule only looks at what amount you can withdraw from your portfolio in total. Taxes and fees need to be paid out of that withdrawal. If most of your portfolio is in tax-deferred accounts like a 401(k) or IRA, you will have a higher tax burden when you withdraw the money, which should be considered.

As you can see, the 4% rule is a very simplistic way of considering what you can spend in retirement. We believe taking the time to go through a comprehensive retirement planning analysis to consider your unique situation is important. 

One of the keys to this analysis is to look at your current spending and to think about how that spending might change in retirement. That spending should be broken down between essential and discretionary expenses, and as this article from Michael Kitces points out, it helps to identify the core vs adaptive expenses.

An alternative to the 4% rule is to take a more dynamic approach to spending in retirement. Also known as a “guardrails” strategy, this would have you spend more from the portfolio when returns are good and reduce spending if the portfolio drops below certain levels. This means you could start your withdrawals at a level higher than the 4% rule, but you’d have to be willing to reduce expenses as needed. 

Regardless of your path, it’s important to regularly update your plan to ensure you are still on the right track in retirement. We are here to help you think through your retirement withdrawal strategy so don’t hesitate to reach out!

-Chris Benson, CPA, PFS

The views expressed represent the opinions of L.K. Benson & Company and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person. Please see Additional Disclosures more information.