What is the 4% Rule?

September 4, 2007 by Marcel

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!

15 Comments so far »

Pinyo said

am September 5 2007 @ 9:27 am

I have been looking into this as well, but there’s not a lot written about it. One of the best reference I found so far is from The Retire Early Home Page, which shows various studies done. Overall, the article agrees with your 4%+inflation number, but there are so many factors including asset allocation, market condition, and inflation that can affect the outcome. Interesting stuff.
Brian said

am September 5 2007 @ 10:36 am

It reminds me of dollar cost averaging in that it is one of those things that everybody uses but few really understand. You did a great job of covering that in your recent post on the subject. I’ve wanted to do a similar analysis myself, but you did it for me!
Erabulus said

am September 5 2007 @ 12:50 pm

The 4% rule is a good, conservative estimate of a safe withdrawal rate. Depending on your age, the number of years you expect to be retired, and your risk tolerance, you may be able to go somewhat higher.

There is a great tool called FireCalc that lets you test various strategies, and see how they would have performed in real life based on historical market data.
Brian said

am September 5 2007 @ 3:58 pm

Erabulus: Thanks for the great tool. It is very useful.
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Bob Smith said

am September 26 2007 @ 2:35 am

“Where did it come from? The 4% number… From my understanding, they used a type of Monte Carlo simulation.”

Actually, it came from an analysis of the historical performance of asset classes and inflation. In other words, there’s a presumption that what would have worked in the past, has a reasonable chance of working in the future. John Greaney deserves a lot of credit for his work on this. FireCalc is based on John’s work and is probably the best tool available. Monte Carlo simulations are inferior to FireCalc for reasons too involved to cover in this short space.

“If you are horrible at Microsoft Excel, don
Brian said

am September 26 2007 @ 7:52 am

Bob Smith: Thank you very much for expanding on the origins of the 4% rule. I read so many different sources, and they each had a different origin for the rule.

As for your second point, I think we agree and disagree. I do agree with you that even when doing your own financial modeling or allowing a financial planner to do it for you, you are not getting an exact “this can not fail” number. Each input into the model is an assumption, so the result should be looked at as an estimate.

However, I still think modeled estimates will surpass the accuracy of simply estimating the income you will need in retirement and multiplying by 25. This was what I was trying to get at in the statement you quoted. I’m not a great writer, so I probably should have made that more clear.

If you have a good link where my readers can get more detail on the rule, please feel free to leave it in a comment.
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Self Employed Health Insurance said

am January 11 2008 @ 3:04 am

This is good information. I was wondering about your thoughts on the Infinite Banking Concept as taught by Nelson R Nash? I have tried it for the past year and now that I am into year 2 I am really beginning to see the results of this for paying for my retirement.

Your thoughts?
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am January 17 2008 @ 1:52 pm

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Hey check out this guy too!!!
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George Fisher said

am April 27 2008 @ 4:33 pm

The 4% rule comes from a study that assumed you have a 75% equity/25% debt portfolio and you plan to make inflation-adjusted withdrawals.

Based on the ups and downs of the markets, it looked to see what would happen at different withdrawal rates.

More detail is here:
http://www.georgefisheradvisors.com/assetalloc.php#Withdrawals