Four Percent Rule

BY THE LATE 1990s, with almost two decades of robust investment returns under their belts, investors would talk about 6%, 8% and even 10% as a reasonable rate at which to draw down a retirement portfolio. But researchers begged to disagree—and the financial markets provided brutal confirmation, hitting stock investors with back-to-back bear markets in 2000–02 and 2007–09.

Today, 4% is considered a safe withdrawal rate (though even that number has been called into question). What does that 4% represent? Let’s say you retired with $500,000. A 4% withdrawal rate suggests you would pull out $20,000 from your portfolio in the first year of retirement and thereafter step up that sum each year with inflation. For instance, if inflation ran at 3% a year, you would withdraw $20,600 in year two, $21,218 in year three and so on.

Any dividends and income you receive would count toward the annual sum withdrawn. Also, this 4% is pretax. After all those years of tax-deferred growth in 401(k) plans and IRAs, the tax bill comes due in retirement. Once Uncle Sam takes his cut, you will have less than 4% to spend.

Here’s another way to look at that 4% withdrawal rate: If you know how much retirement income you want from your portfolio, you should aim to amass 25 times that sum by the time you retire. Need $20,000 in first-year retirement income from your portfolio? To generate that sum using a 4% withdrawal rate, you’d want 25 times $20,000, or $500,000, saved by retirement.

According to studies, a 4% initial withdrawal rate coupled with annual inflation adjustments should allow you to make it through a 30-year retirement without depleting your savings. This might seem like a meager income stream. But it’s necessary because of a major danger: sequence-of-return risk.

Next: Sequence of Returns

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Articles: Our Exit Strategy, Riding the Rails, Fire the 4% Rule, Four or Less, Not a Law of Nature, Not Just a Number, Drawing It Down, Rate Debate, About That 4% and Enforcing the Rule