Key Concepts of The Four Percent Withdrawal Rate For Retirement
The Four Percent Rule (a.k.a. 4% withdrawal rate or sustainable retirement withdrawal rate) is a general rule of thumb on annual withdrawals from a retirement portfolio which aids in determining whether you have enough money to retire, regardless of your present age. The sustainable long-term retirement withdrawal rates were originally addressed by Bierwirth (1994), Bengen (1994, 1996, 1997), Ferguson (1996), and Cooley, Hubbard, and Walz (1998). The "Trinity Study" then rehashed the work from Coley et al. (1998) in a 1999 publication stating the following:
This study reports the effects of a range of nominal and inflation-adjusted withdrawal rates applied monthly on the success rates of retirement portfolios of large-cap stocks and corporate bonds for payout periods of 15, 20, 25, and 30 years. A portfolio is deemed a success if it completes the payout period with a terminal value that is greater than zero. Using historical financial market returns, the study suggests that portfolios of at least 75% stock provide 4% to 5% inflation-adjusted withdrawals. Source
Using these findings, many recent analysis have continued to run the numbers to see if the 4% sustainable withdrawal rate is still valid. In most analysis, the 4% rate has held up well for periods up to, and occasionally beyond, 30 years. However, going back to Bengen's original research on the withdrawal rates, there are some serious assumptions that need to be addressed and understood by anyone beginning to consider drawing down on their retirement portfolio, or "nest egg".
How To Apply The 4% Rule
When evaluating your retirement portfolio, according to Bengen, you may make a first-year withdrawal of 4 percent of your portfolio. Each year that follows, you may adjust for inflation to maintain the purchasing power of your dollars. The problem is, Bengen does not seem to suggest how to "adjust for inflation" with these withdrawals. My assumption- to which I may be incorrect- is that you can take your initial 4% withdrawal, and multiply by the anticipated rate of inflation for the year. You may either Google expected inflation rates, or attempt to calculate them on your own which typically requires you to understand changes in the CPI, as well as have a crystal ball since you take the full year's change in CPI.
For example, let’s say your portfolio at retirement totals $1.2 million. According to the 4% rule, you may withdraw $48,000 in Year 1. If inflation expects to be 3% next year, you can give your initial $48,000 a 3% raise of $1,440 to equal $49,440 for Year 2, and so on for the remaining 30 plus years.
Most people will stop right there and assume that they can calculate their level of financial independence simply using their net worth. This is not true!
Additionally, many people need to understand the premises that exist that make the 4%
The Three Major Assumptions That Make "The 4% Rule" Work
Assumption #1 - According to William Bengen, he assumed a balanced portfolio of 50% equities and 50% intermediate term treasuries which are rebalanced. His analysis did prove that up to 75% stocks and as low as 25% bonds would suffice as well.
Most people do not have this type of asset allocation. To reiterate, Bengen suggested keeping a stock allocation of at least 50%, but no more than 75%, of your overall portfolio. The remaining would be invested in intermediate-term treasuries. Consider that most of you, in fact, do not have every last dollar invested in their retirement portfolio the way Bengen's research suggests. Rather, you likely hold some of your money in cash, CD's, money market funds, and checking and savings accounts that are not exposed to the market which is what makes the 4% rule work.
The trick is, you need the growth-potential of stocks combined with stability of bonds (especially with dismal interest rates on other savings vehicles) to keep your portfolio alive for a minimum of 30 years. Therefore, every dollar you have outside of this portfolio is best considered emergency or supplementary funds and not used in calculating your financial independence number.
Assumption #2 - The funds in which you will be drawing 4% from are in tax-deferred vehicles such as traditional IRA's, 403(b)'s, 401(k)'s, pensions, or 457(b) plans. This is a major misunderstanding in the F.I. community!
The reason this is such a big issue is because capital gains and dividends are not taxed as they continue to grow inside a tax-deferred vehicle. You will thus only be taxed on withdrawals from these accounts which will be taxed as ordinary income, not capital gains or dividend rates. This also assumes that you are of proper age- or met one of the IRS exceptions to early withdrawal penalties- to make your withdrawals after the age of 59 1/2.
Sure, there are exceptions of withdrawing from retirement funds without penalty for scenarios such as financial hardship, first time home purchase exclusions, and others. However, Bengen did not account for those! Therefore, in order to be valid and effective, the 4% rule was based on your money being entirely in tax-deferred accounts.
Bengen actually said the following in his paper:
Further, you may not include home equity or other savings and investments outside of stocks and bonds, in the above proportions, when calculating your financial independence number. The reason for this is because the research did not analyze this, therefore we have no idea how it may hold up over time.
Assumption #3 - You never draw above 4% in any given year on your portfolio. This means if there is an emergency expense in a given year, you need to have either income from another source, or outside savings that are not part of your retirement portfolio to cover them. Further, you may not give any of your principle away since your initial 4% calculations were based on you not reducing your principal in any given year by more than 4%. This becomes a problem if you want to give money to heirs while you are still alive since this will likely put you above the 4% annual withdrawal rate.
Look Before You Leap!
Keep in mind, this information is not designed to scare you. Rather, use it to help guide you into making an informed decision. The main takeaway is that when considering your safe withdrawal rate, you must use accounts that are accessible and tax-deferred (Assumption #2) and able to be invested in bonds and equities with tax-deferred growth (Assumption #1). Further, giving a large piece of your retirement portfolio away as a gift- or other unexpected expenses- likely means you need to return to the drawing board to determine your new safe withdrawal rate.