The 4% Rule Worked in the Past. Will It Fail the Next Generation of Retirees?

For decades, the 4% rule has been one of the most widely cited guidelines in the context of retirement planning. The idea is simple -- withdraw 4% of your savings during your first year of retirement, adjust future withdrawals for inflation, and theoretically enjoy a portfolio that lasts roughly 30 years.

The 4% rule has gained a lot of popularity over the years because it addresses a core fear among retirees -- running out of money. The rule is based on actual market data.

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In the 1990s, financial planner Bill Bengen established the rule based on 66 years of historical stock and bond market returns. Bengen examined every 30-year withdrawal period dating back to 1926 to figure out the highest initial withdrawal rate that allowed savings to last 30 years without depletion.

Based on his results, the 4% benchmark was set, and financial experts have touted that guidance ever since. But while the 4% rule may have worked for savers in the past, there are some issues with it that future retirees ought to know about.

Past performance doesn't guarantee future success

The 4% rule makes certain assumptions about stock market returns, bond market returns, and inflation. But the reality is that we don't know what's in store for the economy and market in the coming years and decades.

In recent years, bond yields have picked up enough to make Bengen's 4% rule viable. But if bond yields fall sharply, the rule may no longer work to sustain a portfolio for 30 years. Similarly, a period of above-average inflation could make the rule a risky one.

When living costs rise rapidly, the 4% rule's annual inflation adjustments could be higher than expected. If increased withdrawals coincide with a down or flat market, the risk of depleting savings is elevated.

Flexibility matters

Another big issue with the 4% rule is that it's not particularly flexible. The rule basically says to withdraw a certain amount from savings regardless of how the market is doing. But dipping into an IRA or 401(k) too heavily during a market downturn increases the risk of eventually running out of money -- especially if that market crash happens early on in retirement.

In fact, a good rule of thumb in retirement is to reduce spending -- and portfolio withdrawals -- when the market is down to avoid having to lock in major losses. That could, for example, mean sticking to a 2% or 3% withdrawal rate for a period of time, depending on how long any given market crash lasts.

How future retirees should use the 4% rule

The 4% rule isn't necessarily bad or even dated advice. At its core, it sends an important message -- have a plan for tapping retirement savings, and don't just take money out at random.

But instead of following the 4% rule exactly, future retirees may want to use it as a starting point, but tweak that guidance based on different factors -- market performance, bond yields, and inflation, to name a few.

It's also important to adjust the 4% rule based on personal circumstances. Early retirement, for example, makes a 4% withdrawal rate riskier. A later retirement -- say, at age 70 or beyond -- might allow for a more generous withdrawal rate.

Portfolio composition matters, too. A bond-heavy portfolio may not generate the returns needed to support a 4% withdrawal rate, even during periods when bond yields trend higher.

With the right tweaks, though, the 4% rule could continue to be a useful strategy for generations to come -- as long as savers understand the risks and limitations.

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