The Big Problem with the 4% Rule

The 4% rule is a very common strategy for taking income during retirement. The author highlights some risk factors to be aware of with this strategy.

The 4% rule has become a very popular rule of thumb over the past few years and for good reasons: it is simple to understand and pretty conservative.

For those that aren’t familiar with the 4% rule, it was designed as a strategy to not run out of money in retirement. Here is how it works:

  • In the first year of retirement, you withdraw 4% of your retirement savings.
  • In subsequent years, you adjust your withdrawal for inflation. 

Note: This rule assumes you invest your savings in 50% stocks and 50% bonds. 

For example, if you have $100,000 in retirement savings at the beginning of retirement, you’d be able to withdraw $4,000 during the first year of retirement. The next year, if inflation was 2%, you’d then withdraw $4,080. Your withdrawals would be able to increase with inflation in all future years as well.

If someone follows the 4% rule, the odds of them running out of money are small.

The Problem

The biggest problem with the 4% rule is that life is almost never as simple as we’d all hope. 

There may be some years in retirement that you need more than the rule allows and some years that you need less. This could be caused by moving locations, health problems, or other life changes.

Before Social Security?

One common situation when you might need more than 4% from your retirement savings is before you start Social Security. 

For example, let’s say you retire at age 60 but don’t plan on taking Social Security until age 67. You may need more than just 4% per year during those 7 years to fill the gap, but after you start Social Security, you may need less than 4% because you have higher fixed income. 

Because there can be significant advantages to delaying Social Security, many people will want to find a strategy to fill this income gap without depleting their retirement savings too much. 

Market Drop at the Beginning of Retirement

The 4% rule works really well in most economic conditions, but the one situation with which it struggles is when the market drops significantly at the beginning of your retirement. 

Let’s do an example.

Let’s say you have $100,000 of retirement savings and per the 4% rule you can take $4,000 for the first year and slightly more for years after that. But if the market dropped 50% like it did around 2008, (assuming you invested in 50% stocks and 50% bonds like the 4% rule suggests), your $100,000 would now be $75,000. 

At the beginning of retirement, you were only taking out 4%, but since the market crash, you are now taking out ($4,000/$75,000) 5.3%. Depending on what the market does in the subsequent years, this could put significant strain on your retirement savings.

Be Flexible

Despite all the issues that might arise with the 4% rule, I am still a big fan. I think the 4% rule is a great place to start for planning purposes but it isn’t always the best place to end. 

The key to a successful retirement is to be flexible and conservative. There is no perfect retirement investment strategy and everyone should have enough wiggle room in their retirement plan to deal with the unexpected along the way. 

About the Author

Dallen Haws is a Financial Advisor who is dedicated to helping federal employees live their best life and plan an incredible retirement. He hosts a podcast and YouTube channel all about federal benefits and retirement. You can learn more about him at Haws Federal Advisors.