Rules of thumb are popular for a reason. They're simple, familiar and can set a good starting point for grappling with complicated questions. But in retirement planning, there's one guideline that experts say is badly in need of an update: the 4% rule.
The idea is straightforward: Over the course of your first year of retirement, withdraw about 4% of your 401(k) or other defined-contribution plan. In the next year, withdraw another 4%, plus a bit extra to account for inflation. Each year after that, rinse and repeat.
But what happens in an economy like today's, in which stocks are plunging and inflation is soaring? Any retiree relying on the 4% rule is faced with two simultaneous threats: Their portfolio is rapidly losing value, and the yearly inflation adjustment could be untenably huge.
"It's really difficult to put into words how awful this year has been," said David Blanchett, the head of retirement research at PGIM, the investment advising wing of Prudential Financial. "If a client walks into your office, you can't just say 4%!"
Blanchett and other retirement experts recently spoke at a
"It's not meant to be a retirement plan. It's meant to be a guideline for a portion of a retirement plan," said David Lau, DPL's founder and CEO. "Too many advisors and too many individuals self-managing their retirement are using this as the retirement plan: 'This is the safe withdrawal rate. As long as I withdraw 4%, I'm going to be safe.' That's oversimplifying things."
History of a magic number
For such a popular idea, the 4% rule has a surprisingly short history. It was born in 1994, when the financial advisor William Bengen proposed it in an
"Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe," Bengen wrote.
In 1998, three finance professors at Trinity University in Texas published a paper nicknamed
Even today, research continues to support the rule. A recent
"Historically in the U.S., 4% has been that safe initial withdrawal rate," Blanchett said. "We can quibble with a lot of the assumptions of the analysis, but that's not a bad starting place for most retirees… I think the problem is this is an incredibly generalized rule that should be a very, very basic starting point, but it's used a lot more by advisors today than it ever was intended to be."
New territory
As with any other general rule, the devil is in the details. For one thing, people forget some of the specific conditions on which Bengen based his calculations. Consider this less well-known sentence of his article:
"It is appropriate to advise the client to accept a stock allocation as close to 75 percent as possible, and in no cases less than 50 percent," Bengen wrote.
In the 1990s, when U.S. stocks were booming, perhaps it was a no-brainer to devote at least half of one's retirement plan to equities. But in today's volatile market, that looks a lot less "safe." For example, the classic 60/40 portfolio (60% stocks, 40% bonds — another rule of thumb) is down 20% this year, its worst showing since 2008, according to
"The research work that led to the 4% rule is very specific in terms of the asset allocation… It's not a 'whatever,'" said Frank O'Connor, the vice president of research at the Insured Retirement Institute. "So you can't create an ultra-conservative portfolio that's only 20% allocated to equities and be aligned with that original research."
The other detail people forget, O'Connor said, is the adjustments for inflation. In the mid-to-late '90s, inflation was low, so these adjustments would not have broken the bank. But in the 2020s, inflation at its highest level in four decades — in September, the consumer price index rose 8.2% over the previous year. So tweaking that 4% every year to keep up with rising prices could be very costly.
"If you're in a very inflationary environment, then those income payments are going to increase a lot more substantially, and that's going to mean much higher withdrawals from the portfolio," O'Connor said. "We're in new territory."
Time for an update?
In an economy where retirement portfolios are already shrinking, making increasingly large withdrawals from them may not be sustainable. Even the rule's originator predicted this problem in a 2021 interview.
"I think of a retirement portfolio as a balloon with two holes," Bengen told
Today returns are low and inflation is high. If followed too rigidly, experts say, the 4% rule could be a recipe for rapidly depleting one's assets. So what's the solution? Some suggest a simple fix: lowering the percentage.
"If your expectation is that you're going to have to withdraw a lot more next year, and the year after, and the year after that… then you'd better start lower," O'Connor said. "The higher inflation is, the lower the initial percentage withdrawal should be."
Others have put forward this remedy as well. A
"Recent Morningstar research shows that the 4% standard for in-retirement withdrawals may be a bit too aggressive," Morningstar wrote in a
Another solution is to rely less on a number and more on an advisor. Working with a professional, retirement savers can form a plan that's tailored to their particular finances, rather than using a one-size-fits-all rule.
"If a client brings up the 4% rule or even asks about taking regular income from a portfolio, I think that's an outstanding opportunity for the advisor to describe a few different ways to do that," O'Connor said.
Blanchett echoed this advice.
"Four percent is a good starting place," he said. "Then go get help."
