What is the 4% Rule?

If you have spent a lot of time reading about retirement planning or discussing it with your financial advisor, you have probably heard of the 4% rule. This rule causes a lot of confusion when I discuss it with family and friends. The rule itself is not complicated, but it seems that everybody has their own version of what it means and its use. I’ll try to use this post to clarify the rule and hopefully give a better understanding of its application in retirement planning.

What exactly is the 4% rule?

The 4% rule is a rule of thumb that says you should withdraw 4% of your nest egg in your first year of retirement and increase it annually for inflation. That’s it.

Where did it come from?

The 4% number is a result of a bunch of very smart people modeling how long a nest egg would last given certain withdrawal rates. From my understanding, they used a type of Monte Carlo simulation. They determined that, given a 4% initial withdrawal rate increased annually for inflation, a nest egg could last around 30 years with a decent probability.

How can it be applied to planning my retirement?

If you are horrible at Microsoft Excel, don’t have a financial planner, or just want to “wing it”, then the 4% rule may be for you. I tend to use the 4% rule backwards. Instead of figuring what I can withdraw from a sum of money, I figure what sum of money I need to maintain a withdrawal that suits me. For instance, if I want $50,000 in my first year of retirement, I will need $50,000 x (100%/4%) or $50,000 x 25 = $1,250,000. Remember, the $50,000 is in future dollars, so it will not buy the same amount that $50,000 does today.

Other thoughts

The 4% rule should not be used as the end of your retirement planning process. It does not take into account your asset allocation at retirement time. In general, the more of your portfolio that is allocated to stocks at portfolio, the better the odds that your money will outlive you. However, as is the nature of stocks, your portfolio will be extremely volatile which could send you back to work after a couple of bad years.

Another way to look at the 4% rule is as a middle point between risk tolerances. If you don’t have a high life expectancy, you can certainly pull out more than 4% in order to enjoy the life you have left. This is also the case if you have other types of income to support you such as a pension or annuity. If, however, you think you will be around for a while, you may opt for a lesser withdrawal.

When all is said and done, you still have to accumulate that nest egg. Make sure to define your investment goals, start saving, and continually monitor your asset allocation. The 4% rule gives you a target to reach – now go hit it!