Sorry, But There's Nothing Particularly
Magical About the 4% Withdrawal Rule
December 2010
In the December 1, 2010 issue of the AARP Bulletin, personal finance expert Jane Bryant Quinn
indicates that one of the three keys to making accumulated retirement savings last a lifetime is
to withdraw no more than 4% of retirement savings in the first year of retirement. According to
Ms. Quinn 4% is the magic number for retirement budgeting. Her online article refers readers to
the Wikipedia section on William Bengen, a Certified Financial Planner generally credited with
development of "the Four Percent Drawdown" (or 4% Withdrawal) rule.
This article will describe the 4% Withdrawal rule and some of its strengths and shortcomings. In
summary, the 4% Withdrawal rule should be used with some caution. While the 4%
Withdrawal rule is a simple rule of thumb that can produce reasonable results under certain
circumstances, it can also produce poor results, particularly for individuals whose initial
retirement age is not close to 65, who have other fixed dollar lifetime income or who don't
invest in equities. In addition, after the initial year of retirement, the 4% rule is inflexible and
provides no guidance for making adjustments for changes in investment strategies or for
putting the retiree safely "back on track" if actual experience significantly deviates from the
experience implicitly assumed under the rule (for example if investment experience is unusually
bad or good). With just a little more effort and discipline (as discussed elsewhere in this
website), retired individuals can develop spending budgets that better meet their specific
retirement income needs and needn't rely on "blind faith" as required under the 4% Withdrawal
rule.
Background--The 4% Withdrawal Rule
For his October, 1994 article in the Journal of Financial Planning, William Bengen conducted a
number of drawdown simulations based on historical investment performance and concluded
that a person retiring at age 65 who invested approximately 60% of her retirement assets in
stocks and the remainder in fixed income securities and withdrew no more than 4.2% of such
assets in the first year of retirement and no more than the first year withdrawal amount
increased by subsequent increases in price inflation in each future year, would be expected to
make such withdrawals for at least 30 years. Based on assumed mortality experience at the
time (and now), a period of thirty years would be expected to exceed the lifetimes of most
individuals who retire on or after age 65. As a result of this research, Ms. Quinn and many
financial planners advise clients to use this 4% Withdrawal rule when budgeting how much of
their accumulated assets may be spent each year.
It is important to note that the rule applies in the first year of retirement and is blindly increased
with increases in inflation thereafter. There is no adjustment for actual experience. Some
financial experts like Ms. Quinn have indicated that retirees should, "crunch the numbers every
5 years or so" to get safely back on track, but this is not anticipated under Mr. Bengen's rule and
no guidance is provided as to how one should go about this "adjustment" process. While Ms.
Quinn does mention that you might be able to apply a 5% withdrawal rule if you are looking at a
20-year payout period, the implication is that if you are trying to get back on track, you may
need to reapply (or "restart") the 4% rule to your existing assets as if you were in your first year
of retirement. As discussed below, restarting the 4% rule may be an overly conservative
action.
As discussed elsewhere in this website, If you desire to have relatively stable retirement
income from year to year measured in real (after inflation) dollars for the rest of your life, the
amount of accumulated savings that may be safely withdrawn each year will depend on a
number of factors, including:
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
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Investment return on accumulated assets
Inflation
Expected payout period
Amount of other fixed retirement income (that will need to be inflation-adjusted) such as
lifetime payments from a defined benefit plan or lifetime income insurance product, and
Amount of assets desired to be left to heirs
4% Rule--Strengths:
The 4% Withdrawal Rule is very simple to apply and under certain circumstances, it can
produce reasonable results. In the initial year of retirement, the 4% Withdrawal Rule is
reasonably consistent with the simple spreadsheet contained in this website ("Excluding Social
Security") based on the following input items: a 2% real rate of return (investment return that is
approximately 2% greater than inflation), a 30-year payment period, no amounts to be left to
heirs and no other fixed income sources. For example, if you input $1,000,000 of accumulated
savings, 5% investment return, 3% inflation, 30 year payout period, $0 lifetime income and $0
amount left to heirs in the spreadsheet, you will get a first year spendable income amount from
accumulated savings for the first year of $43,449, or 4.3% of the beginning-of-year accumulated
savings. We will call this set of input items the "baseline assumptions" for the 4% withdrawal
rule. If actual experience exactly follows these baseline assumptions, the 4% Withdrawal rule
will work well.
In addition to being simple, the key strength of the 4% Withdrawal Rule is that for a person who
has no other fixed income annuity income, the rule automatically provides the same level of
inflation-adjusted income for each year of retirement. If the amount withdrawn is adequate for
the initial year of retirement, the amount withdrawn in subsequent years will be the same (in real
dollars), and presumably will remain adequate.
4% Rule--Shortcomings:
Problem #1. 4% Withdrawal Rule Doesn't necessarily work well if baseline assumptions
don't apply. The 4% Withdrawal rule may not work very well if assets are not invested
60%/40% equities and fixed income (or don't earn a 2% real rate of return), the expected payout
period at the initial retirement age is not 30 years, you have significant amounts of other lifetime
payments that are not indexed to inflation or you desire to leave significant amounts to your
heirs. For example, assume the same $1,000,000 nest egg, but let's assume investment
return of only 4% per annum, inflation of 4% per annum (a zero percent real rate of return), a
40 year payment period (which might be more consistent with a couple with the younger spouse
age 55 at retirement), a 25,000 annual annuity payment from a defined benefit plan and a desire
to leave $200,000 to heirs upon death of the last surviving spouse. Inputting these items in the
simple "Excluding Social Security" spreadsheet, we get an initial withdrawal from accumulated
savings of $11,824, or 1.2% of the initial savings, far lower than the 4% "magic" number.
On the other hand, let's assume investment return of 6%, inflation of 3% (approximately a 3%
real rate of return), a 20-year payment period (which may be consistent with an initial age at
retirement of 75, for example) and no amount left to heirs. In this case, we would get an initial
withdrawal amount of $64,787, or 6.5% of the initial amount of accumulated savings of
$1,000,000. Under these assumptions, the initial withdrawal would be significantly in excess of
the 4% "magic" number, and while a person who employs the 4% Withdrawal rule under these
circumstances will not run out of money, he or she may leave significant amounts upon death
that could have been spent during the retirement years.
All things being equal, the shorter the payout period, the higher the safe withdrawal rate
measured as a percentage of accumulated savings. This can be seen by changing the
expected payout period in the simple spreadsheet under the baseline assumptions. For
example, a person with a 20-year payout period can withdraw almost 6% of accumulated
savings in the first year, and a person with a 10-year payout period can withdraw almost 11% of
accumulated savings in the initial year. If you look at the "Runout tab" in the simple
spreadsheet, you will also see that if all assumptions are realized, the spendable amount will
increase as a percentage of accumulated savings each year.
Problem #2. 4% Withdrawal Rule Does Not Adjust for Experience Gains or Losses. The
4% Withdrawal rule is applied in the initial year of retirement and is adjusted only for subsequent
increases (or decreases) in inflation. Despite Ms. Quinn's suggestion to revisit the numbers
every five years, there is no adjustment mechanism in this rule if experience is more or less
favorable than implicitly assumed. Let's illustrate this problem with a few examples.
Mr. A retires at age 65 on March 1, 2008 with accumulated savings of $1,000,000 and follows
the 4% Withdrawal rule. He invests his accumulated savings in accordance with Mr. Bengen's
"reasonably diversified" 60%equity/40% fixed income strategy. On March 1, 2008, Mr. A
withdraws $40,000 (4% of $1,000,000) and deposits it in his bank to be used as his retirement
income for the next 12 months. As a result of the drop in the stock market (the S&P index fell
more than 40% during this period and Mr. A's total investment experience for the 12 months
was -25%). His accumulated savings as of March 1, 2009 is now only $720,000 [($1,000,000 $40,000) X .75] . Let's assume that inflation for the first twelve months of Mr. A's retirement
was 0% (it was actually slightly negative for this period). What should Mr. A do as of March 1,
2009 to determine his retirement income for the next 12 months? If he blindly follows the 4%
Withdrawal rule, he will again withdraw $40,000, or about 5.6% of his depleted accumulated
savings at that time. Interestingly , had Mr. A deferred commencement of his retirement by one
year, he would have assets of $750,000 (assuming the same investment experience on his
$1,000,000 and no additional savings) and his initial withdrawal would have been only $30,000
(.04 X $750,000). Thus, the 4% withdrawal rule can produce significantly different results
depending on investment experience just before retirement.
Instead of following the 4% Withdrawal rule on March 1, 2009, Mr. A may adjust his spending
plan in some manner to reflect the disappointing 2008 investment experience. In this situation
the adjustment is easy according to Ms. Quinn. She suggests that Mr. A should pretend that
his initial year of retirement is actually 2009, not 2008, and reapply (or restart) the 4% rule to
obtain a revised spending budget of $28,800 (.04 X $720,000).
But, what if the initial year of retirement was some time ago. What should a long-term retiree
do after a particularly bad (or good) investment year? As discussed above, the 4% Withdrawal
rule does not provide for adjustments. Let's assume that Ms. B retired at age 65 on January 1,
2001 with $1,000,000 of accumulated savings and has been following the 4% Withdrawal rule
(including the 60% equity/ 40% fixed income investment regime) since that time. The chart
below shows the history of Ms. B's accumulated savings and withdrawals under the 4% rule,
based on increases in the S&P 500 index for equities, CPI-U and the Ryan Labs Corporate
Bond Index (SMA 200) for fixed income. The chart shows that by following the 4% Withdrawal
rule, Ms. B was able to weather the poor investment results of 2001 and 2002 and still stick
with the 4% Withdrawal rule without adjustment. Like many other retirees, her accumulated
savings suffered a significant decline 2008. So, at the beginning of 2009, she had a choice to
make. She could either stay the course with the 4% rule or she could somehow adjust for the
poor 2008 investment experience. If she restarts her withdrawals at 4%, she will withdraw only
$30,440 (.04 X 761,007) for 2009, or only about 63% of the 2008 withdrawal. Alternatively, she
can continue to have faith that the 4% Withdrawal rule will continue to meet her needs and she
will not outlive her savings. Interestingly, the stock market has bounced back in the past few
years, and with 20/20 hindsight at the beginning of 2011, it looks like Ms. B probably didn't need
to make any adjustments to her 2009 spending plan as a result of the poor investment year in
2008.
Illustration of the 4% Withdrawal Rule--Retirement on January 1, 2001
YEAR
BOY
Accumulated
Savings
2001
$1,000,000
2002
$944,640
2003
Prior Year
Inflation
Factor
BOY
Withdrawal
Investment
Return Factor
EOY
Accumulated
Savings
$40,000
0.984
$944,640
1.0155
$40,620
0.8817
$797,074
$797,074
1.024
$41,595
1.2411
$937,626
2004
$937,626
1.0188
$42,377
1.0888
$974,747
2005
$974,747
1.0326
$43,758
1.0517
$979,121
2006
$979,121
1.0342
$45,255
1.0947
$1,022,303
2007
$1,022,303
1.0254
$46,404
1.0645
$1,038,844
2008
$1,038,844
1.0408
$48,298
0.7682
$760,938
2009
$760,938
1.0009
$48,341
1.2388
$882,765
2010
$882,765
1.0272
$49,656
1.101
$917,253
2011
$917,253
If retirees want to be safe and not outlive their accumulated savings, they can always "restart"
the 4% withdrawal rule after a poor year of investment results. Doing so, however, may result in
a very significant drop in annual spendable amount, particularly if the retiree is older and has
been retired for some time. As discussed above, a retiree with 10 years left can safely
withdraw something in the neighborhood of 10% of assets unless she wants to leave significant
amounts to heirs. Therefore, restarting withdrawals at 4% at an advanced age will likely be
overly conservative. And while it is important to be conservative and not to outlive one's assets,
it is also important to many retirees to enjoy their retirement years and not leave significantly
more assets than intended when they die.
Conclusion
The 4% Withdrawal Rule is based on a specific asset investment mix, retirement at about age
65, no other fixed lifetime income and no amounts to be left to heirs. It provides no clues as to
how the spending budget is to be adjusted for changes in these items and no adjustments for
unusually good or bad investment experience subsequent to retirement.
As noted in one of the links on this site, researchers have warned about the use of the 4%
Withdrawal rule. Nobel Laureate William Sharpe has said that "what's really wrong with the 4%
plan is its insistence on fixed spending coupled with investing in a portfolio with variable
returns."
Instead of trying to make adjustments to the 4% Withdrawal rule to make it work, I believe that
retirees should be revisiting their spending budget at least once every year and making
necessary adjustments (applying an algorithm) to reasonably spread the difference between
expected end-of-period-assets with actual end-of-period assets (i.e., experience gains and
losses) as discussed in this website. There is no need to blindly follow the 4% Withdrawal rule
or to somehow try to figure out how to adjust it periodically to make it better reflect your specific
circumstances or to have it reflect emerging experience gains and losses.
The article in this website (Self Insuring Your Retirement? Manage the Risks Involved Like and
Actuary) includes a suggested algorithm for adjusting experience gains and losses (taking 50%
of the spendable amount based on actual accumulated savings and 50% of the expected
spendable amount based on prior year's accumulated savings). The article also indicates that
other/better algorithms may be developed. Retirees who like the real-dollar consistency of
withdrawals inherent in the 4% Withdrawal rule, may wish to adopt an algorithm that adjusts the
previous year's spendable amount for inflation for the previous twelve months (as is
contemplated under the 4% Withdrawal rule) provided that the resulting spendable amount
remains within some specified corridor of the spendable amount based on that year's actual
accumulated savings and the simple spreadsheet contained in this website. If the inflation
adjusted spendable amount fell outside the corridor, the algorithm could provide, for example,
that the adjusted spendable amount would be equal to 50% of the spendable amount based on
actual accumulated savings and 50% of the inflation-adjusted spendable amount.
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As discussed in the March 2010 article contained in this website, there are many risks associated with self-insuring your own retirement. The
general process described in the article and sample spending calculators in this website are made available to you as self-help tools for your
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(in this case, your “annual spendable amount”) is a function of the accuracy of the data and assumptions that you input. Since you control
these items as well as investment of your accumulated savings, we can make no claims or guarantees that you will not outlive your
accumulated savings or experience significant decreases in amounts that may be spent in a future year if you follow the process described in
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compared with some other strategy. All articles and sample spending calculators on this website are provided purely for your educational
purposes. You are encouraged to seek professional advice from qualified investment/financial professionals before committing to any
retirement spending plan and should not simply rely on the results you may obtain with the process and sample spending calculators described
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