The 4% rule has become sacred ground in the FinTwit space. In case you’ve been living under a rock, the 4% rule is the result of a study that showed that you have a very good chance of making your retirement savings last 30 years or longer if you followed the simple method. Today we’ll look at how the system works, how the study was performed, and variations on the plan that might be better than using the 4% rule religiously.

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How does the 4% rule work?

The 4% rule states that if you withdraw a maximum of 4% of your retirement account value and then just increase the amount you withdraw each year for inflation, you’ll have a very good chance of making your money last at least 30 years. In many scenarios you’ll have at least as much money remaining after 30 years as you had to start. For example, if you start out with $2M in retirement assets, you would withdraw $2M x 0.04 = $80,000 the first year.

Then, for year two, you would increase your withdrawals based on inflation. For example, if the CPI were 5% that year, you’d withdraw $80,000 x 1.05 = $84,000 the next year. In this way you’d be able to increase withdrawals each year and maintain the same level of spending that you had the first year, so you should be able to maintain the same level of lifestyle you had in the first year. In 15 or 20 years, you might very well be withdrawing $160,000 each year or more.

Because inflation would cause your account value to increase (if held for long enough), your account value should increase and keep up in higher inflation times, allowing you to make these numerically larger withdrawals. (Because it will take more dollars to buy the same number of shares of a company, just as it will cost more to buy other things because of inflation.) The amount withdrawn should be small enough to not remove too much money during down years, and therefore you should be able to make it through retirement without running out of money and even have some money to pass on to your heirs.

To reduce the level of fluctuations, a mix of bonds and stocks is used. A typical rule-of-thumb, thanks to Jack Bogle of Vanguard, is to hold your age in bonds minus 10 and then have the rest in stocks. The bonds provide income and help keep account value up during stock market crashes and the stocks grow with inflation, plus some, addressing the issue of inflation eroding spending power. (If you’d like to learn more about how to decide how much you should put in different types of assets, Sample Mutual Fund Portfolios gives lots of information and examples of how to make allocations for all sorts of different goals, including retirement.)

How was the study done?

The study used a technique called “Monte Carlo simulation.” This technique is also used to model such things as space capsule heat shield heating and ablation when it first enters the atmosphere, the spread of viruses through a population, and the uncertainty in measurements when doing experimental testing. Here’s how it works:

1. Start out with a person with $2M in a portfolio with a given stock/bond allocation.
2. Assume they take 1%, or $20,000 out in year one.
3. Based on how they are invested and the possible range of yearly returns for their investments, use a random number generator to determine how much they made or lost in year 1. Here, one of the possible returns is picked at random.
4. Determine their account value at the start of year 2:

Year 2 Value = Year 1 Value ($2 M) – $20,000 + gain (or – loss)

You then have the account value at the start of year 2. You’d repeat the process, now starting with the year 2 value. Instead of taking out 1%, you’d take out $20,000 plus inflation. For example, if you assumed 3% inflation per year, you’d take out 1.03 x $20,000 = $20,600. This would be done for 30 years to determine the value at the end of year 30.

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This is one possible outcome of withdrawing 1% each year. You’d record the result, then start again with the same $2M and go through all 30 days again. Because the amount lost or gained each year is random, you’d get slightly different outcomes each time you did this, just as people in real life would see different results depending on what happened to the markets while they were retired. This is repeated again and again until a large set of possible outcomes are assembled into a database. Statistics are then done on this database.

For example, you could calculate the average amount left after 30 years for all of the cases in the database You could also calculate the number of times you ran out of money before reaching year 30. Once you finished this for a 1% withdrawal rate, you’d do it again for 2%, 3%, 4%, 5%, etc…. Obviously this would take a very long time to do by hand, but if you program it into a computer, you can run a huge number of cases very quickly.

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What were the results?

After following the procedure above with several different withdrawal rates, it was found that you could take about 4% of an account and then increase each year for inflation and not run out of money within 30 years almost all of the time. Because people who are entering retirement are interested in knowing how much they can take out, financial advisors seized on this number and it became known as “The 4% rule.” Of course, it relies on having the same stock/bond allocations as those used in the study, which, again, were found through Monte Carlo simulations to be optimal for reducing the chances someone would run out of money within 30 years.

Now, it is also true that if you look at long-term returns from large-cap stock indices, you’ll find an annualized rate of return of about 10%. After inflation, because inflation has been running at about 3% for many, many years because the Federal Reserve adjusts money supply to keep it there, after-inflation annualized returns of 7% are realized. This means that you should be able to take out around 7% the first year and then adjust for inflation, right? Why isn’t it the 7% rule or even the 8% rule?

The answer is an issue called “sequence risk. If you put a lump sum of money into a large-cap index fund and didn’t touch it for 30 or 40 years, assuming things don’t change over the next 30 to 40 years, you’d see annualized returns of around 10% before inflation. This means you could do a pretty good job of estimating how much you’ll have in 30 or 40 years in such an account. Just go to a compound interest calculator and plug in some numbers with a 10% APR.

But it is different when you start withdrawing money because that introduces something called “sequence risk.” This points to the fact that the sequence over which you see returns each year over the period matter even if you have the same annualized returns at the end of the period. The issue is that if stocks go down right at the beginning, you’ll be selling assets and taking out money when assets are low in price, meaning that even if they rally and go way up later, you won’t get the same amount of money you would have gotten if they had rallied early. Because you sold assets when they were low in price, you miss out on the return they would have provided because they weren’t in your portfolio to provide the additional money to you. When assets go up early, you reduce your account value less, meaning that you’ll have more money even if they decline in price later. Here, you’ve taken out money before the fall in prices.

For example, if you invest a lump sum in an account and returns for a 4-year period are +10%, -11%, +50%, -25%, you’ll end up about 10% from where you started. If alternatively your returns were -25%, +50%, -11%, +10%, you’ll also end up about 10% higher. Both scenarios produce the same 10% return over the four-year period, or an APR of around 2% per year.

But if you were to withdraw $100,000 per year from a million dollar portfolio in the first sequence, your account value at the end each year would be:

Year 1: ($1M – $100,000) x 1.1 = $990,000

Year 2: ($990,000 – $100,000) x 0.89 = $792,100

Year 3: (792,000 – $100,000) x 1.5 = $1,038,150

Year 4: (1,038,150 – $100,000) x 0.75 = $703,612.50

For the second sequence, your account values would be:

Year 1: ($1M – $100,000) x 0.75) = $675,000

Year 2: ($675,000 – $100,000) x 1.5 = $862,500

Year 3: (862,500 – $100,000) x 0.89 = $678,625

Year 4: (678,625 – $100,000) x 1.1 = $636,487.5

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So, because the really bad year (-25%) came earlier in the second sequence than it did in the first, forcing you to sell out shares when they were depressed to make the withdrawals, you ended up with about $70,000 less at the end of four years. This is sequence risk. If a retiree has a bad year or two at the start of retirement, it can drive down account values to the point where he cannot recover and will run out of money before he dies. If he has the inevitable bad years later in retirement, he can make it through just fine.

Alternatives to the 4% rule

The 4% rule gives a pretty good first estimate of how much you’ll need for retirement, but it can be improved in several ways. These include:

The 3% Rule: Because many people are living longer than 30 years, a suggestion has been made that people use a 3% rule where only 3% is withdrawn the first year and then adjusted for inflation from there. This would mean that if you needed $50,000 per year in retirement, instead of just needing a $1.25M portfolio like you would under the 4% rule, you’d need a $1.5M portfolio. It definitely isn’t a bad idea to be conservative here since it would be terrible to run out of money after you were out of the workforce for many years and elderly, so the 4% rule should be seen as a maximum, not a minimum withdrawal.

Adjust based on results: So, let’s say that you retire and take out 4% the first year, but then the markets have a huge rally and your portfolio goes up 20%. Can you then readjust and take out 20% more? The answer is, yes, since what you’re basically doing is starting again and using the 4% rule from the year after you originally retired. The math works the same way, where as long as you’re not taking out more than 4% of account value, you have a really good chance of making it 30 years.

If, conversely, you have a really bad year right after you retire, it wouldn’t be a terrible idea to adjust your withdrawals downwards if you can. The 4% rule is still working for you where most of the time you’d still make it through retirement even if you had a bad year right after retirement. In fact, because you had a bad year, chances are good that you’ll have a good year soon after because stocks will eventually return to their fair valuation which is based on earnings. But the rare times in the 4% rule where you do run out of money and those times are almost always where there is a really bad year near the start of retirement. If you have a bad year and are able to reduce for a year or two and still pay for things you need, it will increase your chances of making it. If things recover, you can always increase your withdrawals again.

The 8% rule: A popular financial commentator has received a lot of grief lately for saying that someone could take 8% out per year. It is true that taking 8% out per year and escalating for inflation would be a bad idea. As the study showed, you’d run out of money a lot of the time doing so.

But the commentator is looking at the 10% average returns stocks provide and then figuring you could take 7 or 8%. Actually, it wouldn’t be a bad plan at all to take 7 or 8% out each year if you reset the amount you took out based on account value. In other words, instead of taking out 8% the first year and then increasing the amount each year due to inflation like you would with the 4% rule, you would simply look at the account value each year and take 8%. This would result in a random amount of income each year, so it would be a good idea to put some of the excess money in the good years into a CD ladder or something to help cover the bad years. But, you would be almost assured of making it through 30 years and more since when there were bad years, you would take less out.

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For example, if your account declined 20% the first year, you’d take out 20% less the second year than you did the first year. If they then rallied and increased 40%, you could increase your withdrawal 40% in the following year. Because stocks return on average 10%, you’d be leaving a few percent of your gains in the account to cover inflation, so your income should also keep up with inflation over long periods of time. Not a bad plan if you could live with the withdrawal fluctuations.

The 2% rule: If you saved up twice as much as you needed to survive, such that you only really needed to withdraw about 2% each year scaled for inflation, it would allow you to leave the excess invested in stocks. The other half of the money would be allocated to stocks and bonds per usual and you would follow the 4% rule for that portion. Then, when there was a really good year, you could take some money from the extra stock portion and either do something really special like a home upgrade, take a big vacation, cover a wedding, or pay tuition for your grandkids, or you could add to the other portion and increase your regular income.

This is a fantastic method since the higher returns you would get from having an all equity portion would result in a lot more income over your retirement. The excess would also mean that if you somehow burned through the original account, you could draw from the excess money and not run out. This is really the best plan since it gives both maximum security and maximum income; however, to get there, you need to save up twice as much as you would to use the 4% rule. But this is easy if you start investing early.

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Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.