A longtime viewer asked me what I think of the 4% rule, and whether it's a useful way to plan for retirement. His question came in by voicemail, and it got a full segment on one of my Wealth-Care Wednesday livestreams. My answer is that it's useful, as long as you know what it was built for.
The rule says you can take 4% of your savings in your first year of retirement, then raise that dollar amount with inflation every year after, and have a good chance of the money lasting. On $1 million, that's $40,000 the first year. If prices rise 3% that year, you'd take $41,200 the next year, no matter what the market did.
It comes from a 1994 study by a financial planner named William Bengen. He tested a portfolio split evenly between stocks and bonds against real market history going back to 1926, looking at every 30-year retirement he could. Four percent was the highest starting rate that never ran out of money within 30 years in the history he tested.
The rule assumes three things. The retirement lasts 30 years, the money sits in a mix of stocks and bonds with low fees, and you take a raise every year, even right after a year the market fell.
If you retire at 55, your money may need to last 40 years or more. The 4% figure came from 30-year tests, and a longer stretch calls for a lower starting rate. Fees come out of the same pot, and every dollar that goes to fees is a dollar the rule assumed you'd still have. And history is only a guide. A retirement that starts right before a long, bad stretch in the market could do worse than anything in the data.
I'd rather not handle that risk only by picking a smaller percentage. My approach is to keep part of the plan in something that doesn't drop when the stock market does. When the market crashes early in retirement, you draw from that part for a year or two and leave the stocks alone to recover. For me, cash value life insurance does that job. Whole life has guaranteed growth, and an IUL, which means indexed universal life, has a floor that keeps a bad year from crediting a loss. Drawing from either one usually means a policy loan, which reduces the cash value and death benefit until it's repaid. Paid-off rental houses can play the same role. A home equity line of credit can too, though credit can be hard to get in a deep recession, right when you'd want it. Retiring into a down market covers why the first few years matter so much.
For someone who wants to own an index fund and not think about it, the 4% rule is a reasonable place to start. Depending on where interest rates go, 3% might be the safer number for some people, or even less. And the rule only covers what comes out of your savings. When you claim Social Security matters just as much, because a bigger check means you need less from savings every year. Claiming Social Security at 62, 67, or 70 covers that choice. I'm a licensed insurance broker, not an investment advisor, so treat this as education and run your own numbers with someone licensed to advise on investments.
Take your savings total and multiply it by 4%, then by 3%. If the smaller number plus your Social Security doesn't cover your basic bills, that gap is what the rest of your plan has to fill.