Back in 1994, former financial advisor William Bengen devised the 4% rule as a spending strategy for retirees. His original paper went into greater detail, but it was boiled down into an idea offering a simple way for people not to overspend their money and outlive their savings. To calculate the total, an individual would add up all of their investments and multiply by 4% to figure out year one. In each year following, inflation would be taken into account in order to determine the new withdrawal amount. For example, if someone had $1 million, the first year would be $40,000. If inflation rose by 5% next year, then he or she would withdraw $42,000 in year two.

The concept is straightforward and was a safe strategy for any 30 year period, even when including the Great Depression, the dot-com bubble, and the 2008 financial crisis, but does it still hold up in today’s economic environment?

As a baseline, the 4% withdrawal rate could still be used successfully. First, having a plan is better than guessing and secondly, the original study ignored Social Security, pensions, and other incomes, so it provides a more conservative estimate.

However, it is not without its faults. As mentioned, other incomes not being accounted for is a potential benefit, but this is not the only consideration left out. For example, the study was based on a 50/50 portfolio and thus disregards risk tolerance. Additionally, the following factors could impact retirement spending when taking portfolio distributions:

-Taxes - Vary state to state and city to city, so an individual’s location is important. They can also be higher or lower depending on what type of accounts are held. Someone with more money in a traditional IRA versus a Roth would theoretically need to take out extra to cover tax implications.

-Medical - It is very difficult to predict what type of medical expenses a person might incur. Different illnesses and treatments have a wide spectrum of costs and can also pop up unexpectedly.

-Stock Market Risk - Everyone knows that the market has its ups and downs, but what if the highs aren’t quite as high as the historical data on which this idea is based? Or if there are more lows in retirement than expected? Charles Schwab is predicting that averages over the next 10 years will be lower than historical norms, which means a safe withdrawal rate may need to be more flexible.

-Interest Rates - Interest rates are much lower today than they were when the original study was conducted in 1994. For example, the average yield for a 10-year treasury bond in 1994 was around 7% compared to just 2.9% today. Lower interest rates can mean lower expected returns for the fixed-income portion of a portfolio, which is a sizable portion of the assumed asset allocation.

With all that being said, the 4% rule could still provide a solid starting point for retirement spending. It is important to not view it as a rigid, set in stone philosophy though. Your situation will differ from other individuals and could change at any point from one year to the next. Taking into account all personal and external factors can help determine an appropriate amount to spend and should be reviewed regularly as part of your overall financial plan.

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Retirement Income