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3 Serious Problems With The 4% Retirement Rule

3 Serious Problems With the 4% Retirement Rule

“The young man knows the rules, but the old man knows the exceptions.”
— Oliver Wendell Holmes Sr.

In finance as in life, depending too rigidly on rules without considering their shortcomings and exceptions can be dangerous. The famous “4% rule” for the withdrawal of funds from a nest egg during retirement is a perfect example.

road sign that says
Image source: Getty Images.

The 4% rule is very simple and handy, but it won’t work for everyone in every situation. Let’s take a closer look at some of its key problems.

Meet the 4% rule

The 4% rule, introduced by financial advisor Bill Bengen in 1994 and later made famous in a study by several professors at Trinity University, says that you can withdraw 4% of your nest egg in your first year of retirement, adjusting future withdrawals for inflation. It assumes a portfolio that’s 60% in stocks and 40% in bonds, and it’s designed to make your money last through 30 years of retirement.

That all sounds pretty good, right? Let’s run through an example. Imagine you’ve saved $400,000 by the time you retire. In your first year of retirement, you withdraw 4%, or $16,000. In year two and every following year, you’ll need to adjust that withdrawal rate for inflation. Let’s say inflation over the past year was at its long-term historic rate of 3%. If so, you’ll multiply your $16,000 withdrawal by 1.03 and you’ll get your second year’s withdrawal amount: $16,480. The following year, if inflation is still around 3%, you’ll multiply that by 1.03 and get a withdrawal amount of $16,974. See? Pretty easy.

3-d human character leaning against a red 4%
Image source: Getty Images.

The advantages of the 4% rule

The upside of the 4% rule is clear: It makes it easy to figure out how much you can safely withdraw from your retirement nest egg each year, while making that nest egg last a long time. After all, one of the biggest retirement fears people have is running out of money.

If you flip it around, the 4% rule can also help you determine how much you’ll need to accumulate in the first place. You first have to know how much annual income you’ll want in retirement, though. Let’s say, for example, that you’d like total income of $60,000, and you expect to collect $25,000 from Social Security. That leaves $35,000 in income you’ll need to generate on your own. It would be your first year’s withdrawal. So if you assume that $35,000 is 4% of your nest egg, then you can multiply $35,000 by 25 to arrive at how big the nest egg will need to be: $875,000. (Why 25? Because 1 divided by 0.04 is 25.)

Here’s a look at the initial-year withdrawals that come with various nest eggs, going by the 4% rule:

Nest Egg

4% First-Year Withdrawal

$300,000

$12,000

$400,000

$16,000

$500,000

$20,000

$600,000

$24,000

$750,000

$30,000

$1 million

$40,000

Hourglass with dollars in the top falling below and turning into sand
Image source: Getty Images.

Serious problems with the 4% rule

Of course, the 4% rule isn’t as perfect and simple as that, as Oliver Wendell Holmes Sr., reminded us. Here are three problems with it.

It’s based on certain assumptions: Remember that the 4% rule wasn’t created to work perfectly in every situation and that it’s the product of certain assumptions. For starters, it aims to make your money last for 30 years, but if you retire at 60 and live to 97, your nest egg will need to support you for 37 years. It also uses a portfolio…

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