The most commonly cited method of withdrawing retirement income from an investment portfolio is “the 4% rule”.

This rule comes from a very popular study conducted by William Bengen and published in The Journal of Financial Planning in 1994 as *Determining Withdrawal Rates Using Historical Data*.

The short-hand version of the rule, and the basic conclusion of the study that is tossed around financial planning circles, is that a retiree can withdraw 4% of their portfolio each year in retirement. This rate would prevent you from depleting your retirement savings before the end of retirement.

The rule does provide a succinct, generalized answer to how much you need to save for retirement or how much retirement income you can take from an investment portfolio.

However, the common interpretation of the rule glosses over some important aspects that I outline below.

This basic rule also serves as a good starting point for understanding other withdrawal strategies. Strategies involving variable spending can be thought of as extensions of this framework.

Beyond determining a withdrawal rate, like the 4% rule, you’ll also want to make sure you consider taxes in your withdrawal plan. Tax-efficient distributions can provide you with a noticeable increase in spendable retirement money.

At the end of the article you can access a calculator that makes it easy for you to find the withdrawal rate that works for you, based on the analysis discussed here.

**The mechanics of the 4% rule**

As I take you through an explanation of the 4% rule, let’s take a look at the underlying principles of how it is meant to be applied.

First, consider the 4%. You apply this percentage to the starting value of your portfolio **AT** retirement. If you have a portfolio of $1,000,000 then 4% of that would be $40,000. If your portfolio is worth $500,000 at retirement then 4% of that would be $20,000.

This 4% amount is what you can withdraw during your first year of retirement. It also serves as the base value for your withdrawals in each subsequent year of retirement.

**Adjusting for Inflation**

The next actionable step of the 4% rule is to adjust your withdrawal amount each year for the **PRIOR** year’s inflation. Inflation is the gradual increase in prices over time. Given how long you’ll be retired, this is a very important consideration.

Suppose that inflation in the year that your retire is 3.5%. If you withdraw $40,000 from your portfolio in the first year of retirement based on a $1,000,000 portfolio value, then your withdrawal in the second year of retirement is $41,400.

The obvious motivation here is to allow your retirement income to adjust with rising prices in order to maintain the initial standard of living or lifestyle.

For each subsequent year that you are retired, adjust your prior year’s withdrawal for the prior year’s inflation rate.

If inflation is 3.3% in your second year of retirement, then you would withdraw ($41,400 + 3.3%) $42,766.20 in your third year of retirement.

**And Deflation…**

To be theoretically sound, I need to also address the issue of deflation. The original study conducted by Bengen calls for making adjustments for inflation whether inflation is positive or negative (deflation). If deflation were to occur, you would reduce the level of spending by the deflation percentage.

While adjusting spending downard following a period of deflation makes sense, most retirees are going to have some psychological aversion to reducing spending that may make this part of the rule unappealing.

**How long will the portfolio last?**

The 4% rule as taken from the study is meant to apply to a retirement lifespan of 30 years. Specifically, a 4% initial withdrawal rate adjusted as mentioned each year for inflation lasted for 33 years in the worst-case scenario.

What were the scenarios? Starting in 1926, and then each year thereafter, Bengen looked at how long a portfolio would last if a person were to retire in that year, given a certain percentage as the initial withdrawal rate (i.e. 4%) and adjusting each year for inflation as outlined above.

He arbitrarily stopped counting after 50 years since that is an abnormally long retirement period that most people will not experience.

Bengen tested withdrawal rates of each whole percentage 1%-8%. A 3% initial withdrawal rate lasted for at least 50 years in every case (no matter which year a person retired). So why is it not the 3% rule? Bengen correctly noted that 3% is too low of a withdrawal rate for most retirees. Most people simply will not have saved enough to maintain their lifestyle with just a 3% withdrawal rate. He also acknowledged that 50 years is an unnecessarily long retired planning horizon.

A 5% initial withdrawal rate took the worst case portfolio longevity down to about 20 years. This may be an acceptable length of time for someone with a shorter life expectancy. However, this is generally too short for most retirement planning projections.

**Inflation’s impact on the portfolio**

By adjusting the income withdrawal each year for inflation, the 4% rule targets a *real *(meaning adjusted for inflation) withdrawal value. It also means that high rates of inflation have a similar effect on the portfolio as do low levels of investment return.

High inflation early in retirement will cause greater concerns much the same way that poor investment returns early in retirement will have a worse effect on the portfolio.

**Asset Allocation**

The other sometimes glossed over aspect of the 4% rule is the makeup of the portfolio. It is widely understood that a portfolio’s asset allocation is a tremendously important determinant of return (and risk). Intuitively then, any rule that seeks to reasonably target a withdrawal that optimizes the balance between retirement income levels (not withdrawing enough) and retirement income safety (withdrawing too much) has to consider the portfolio’s asset allocation. Bengen did.

Bengen considered the effect of five different asset allocations. He looked at 0%, 25%, 50%, 75%, and 100% stock allocations with the remainder in bonds.

He conlcuded that an ideal retirement portfolio would be between 50 and 75% stocks, depending on the retiree’s desire, or lack thereof, for risk.

Notably, retirees having less than 50% stocks in their portfolios would have been much worse off. In each case, the number of years that the portfolio lasted was less than with a 50-75% allocation. Bengen noted then that this did not jive with conventional thought regarding retiree allocation, and that is still the case.

Bengen showed that retirees would in most cases improve their retirement outcome by keeping a little more of their portfolio in stocks. But why is that true? Stocks are expected, over long periods, to provide a higher rate of return than bonds due to their increased risk. This is called the market risk premium.

In order to stomach the volatility of a portfolio with a higher concentration of equities, you may want to segment your portfolio in terms of “buckets” or create a minimum income level using a floor strategy such as a bond ladder with Treasury securities.

**Is it really the 4.5% rule?**

In 2006, Mr. Bengen updated his study (considering more asset classes in the retirees portfolio) and arrived at a 4.5% safe withdrawal rate. The basic parameters and conditions of the study remained the same. Bengen has espoused the 4.5% rate, but the 4% rate seems stuck.

**How do I apply the 4% rule?**

The 4%, or 4.5%, rule provides a good mechanism for benchmarking retirement income. However, more important than the simple statement of the rule itself is an understanding of the research that underlies it.

Why is that true? People are too diverse and retirement is too dynamic to boil it all down to one simple rule. That is not a criticism of Bengen or the rule. He never intended for anyone to blindly apply the rule to all situations.

If you are still are saving for retirement, the 4% rule gives you a good target. First, target an initial withdrawal amount. The further you are from retirement the less precise this value will be but it is still helpful.

Say you are targeting a $60,000 withdrawal. That is 4% of $1,500,000. Consider your asset allocation and the remaining years until retirement. Then, you have a way of thinking about your savings rate.

If you are near retirement the 4% serves as a good benchmark. However, think about the details of the study and make necessary adjustments to fit your specific situation.

**Retirement Income Calculator – Updated!**

Want to know how long your portfolio would have lasted based on the analysis Bengen used to develop the 4% rule? I’ve built the calculator below to do just that and am granting free access to everyone that subscribes to email updates.

Since Bengen is not a known time traveler he was only able to conduct his analysis through the data available in 1992. The calculator below uses data from Ibbotson’s 2016 Stocks, Bonds, Bills, and Inflation Yearbook.

You simply type in your portfolios expected value at the time of retirement, the withdrawal rate you would like to use, and the percentage of your portfolio you plan to hold in stocks. The calculator will then tell you the dollar amount of your first annual withdrawal and the shortest length of time your money would have lasted from 1926-2015 (Ibbotson data lags one year). All of the above analysis is already incorporated into the calculation. Investment returns, withdrawals, and inflation adjustments are all accounted for.