Does the 4% Rule Need an Update?

***This is not financial advice. The information provided is for informational and educational purposes only.***

It's a question on the minds of those in retirement or nearing retirement: how much of your nest egg can you spend each year without running out of money in retirement? In 1994, financial advisor William Bengen published a paper that answered this very question. His 4% withdrawal rule calls for retirees to withdraw 4% from their investment portfolio in the first year of retirement. Then, in each subsequent year, the amount of those withdrawals is adjusted for inflation. According to the rule, this amount is safe enough that you won't risk running out of money during a 30-year retirement.

For example, if a retiree has $1 million in total investment savings, the 4% rule would provide them with $40,000 in their first year of retirement. That would leave $960,000 in investments that would hopefully be growing throughout that year. If the rate of inflation was 3% in your first year of retirement, you would withdraw $41,200 the second year.

What were Bengen's assumptions for the 4% rule? He assumed that by retirement you would have 50% of your investments in equities or stocks and the remaining 50% in fixed income assets like bonds. The 4% rule also assumes that you will receive the full Social Security benefits you expect based on your age, career earnings, and when you start taking them. (Social Security benefits typically replace about 40% of a worker's pre-retirement income.) But there is a chance these payments could decrease by the time you retire.

According to recent research, the 4% rule has its blind spots when applied to today's retirees. Retirement expenses aren't the same each year. If the market experiences more downturns than upturns early in your retirement, your retirement savings may not last as long as it would if the down years come later. The 4% rule assumes that you will increase your spending every year by the rate of inflation - not on how well your portfolio performed - which can be a challenge for some retirees. In addition, life spans aren't predictable; the average life span has increased by a few years since the 4% rule was written. Aging means more doctor's appointments and medical bills in retirement - and many of these additional expenses are often unplanned and unexpected.

What do financial planning experts have to say about the 4% rule? Some recommend looking for an annuity (an insurance contract issued and distributed by financial institutions and bought by individuals, and requires the issuer to pay out a fixed or variable income stream to the purchaser, beginning either at once or at some time in the future) to supplement Social Security and savings. Benjamin Goodman, vice president at TIAA Institute, said, "With an annuity, you know exactly what you can spend, the check, because you're going to get another one next month." He added that annuities are not a fit for all investors, particularly those who have poor health habits or conditions that may prevent them from living long lives.

The 4% rule is difficult to apply to every single person across the board, particularly as they are subject to different tax rates and have different risk profiles and cash flow needs, noted Colin Gerrety, a certified financial planner and client advisor at Glassman Wealth Services in Tysons Corner, Virginia. He added, "Very rarely have I ever seen a client who just withdraws 4% of their portfolio every year, and calls it a day. Things tend to be a lot... messier than that." Like any financial rule, the 4% rule is not foolproof and should be used as part of a broader, diversified financial planning strategy. Since the rule was published, the world - and retirement - has changed. Regular reviews and adjustments in response to changing economic conditions and personal circumstances are crucial to ensure financial stability in retirement.

The content in this article provides general consumer information. It is not legal advice, financial advice, or regulatory guidance.