Why Four Percent For Retirement?

Why are retirement plans often created assuming a 4% withdrawal rate?

When retirement planners try to estimate just how much money a couple or individual should take out of their savings annually, their model scenarios often assume a 4% annual withdrawal rate. Why is 4% used so frequently? Was that percentage plucked out of thin air? No, it actually became popular back in the 1990s.

The “Trinity Study” helped popularize the 4% guideline. In 1998, a trio of professors at San Antonio’s Trinity University analyzed historical market data between 1925 and 1995 in search of a “sustainable” withdrawal rate. They used five different portfolio compositions - 100% stocks, 100% bonds, and 25/75, 50/50 and 75/25 mixes. (For purposes of the study, “stocks” equaled the S&P 500 and “bonds” equaled long-term, high-grade domestic debt instruments.) They tried to see which withdrawal rates would leave these portfolios with positive values at the end of 15, 20, 25 and 30 years.

Their conclusion? If you are retired and withdraw more than 5% annually, you increase the chances of depleting your portfolio during your lifetime.

Subsequently, another such study was conducted by RetireEarly.com using financial market data from 1871 to 1998 – and that report reached the same conclusion.

However, that wasn’t all the study had to say. The “Trinity Study” made some other conclusions that were not entirely in agreement. The professors maintained that most retirees should have 50% or more of their portfolios in stocks. But they also noted that retirees withdrawing just 3-4% a year from stock-dominated portfolios may end up helping their heirs get rich while hurting their own standard of living.

Perhaps most interestingly, the study concluded that an 8-9% withdrawal rate from a stock-heavy portfolio was sustainable for a period of 15 years or less – but not for longer periods. In other words, while our parents and grandparents could confidently withdraw 8-9%, we who might easily live to age 90 or 100 probably can’t.

Another 4% advocate: Bill Bengen. In 1994, CERTIFIED FINANCIAL PLANNER™ practitioner William P. Bengen published a landmark article in the Journal of Financial Planning presenting his own research findings on withdrawal rates from retirement savings. While Bengen published this article in the middle of a long bull market, he factored in the possibility of extended bear markets, minimal annual stock market gains and sustained high inflation.

Looking at 75 years worth of stock market returns and retirement scenarios, Bengen concluded that a retiree who was 50-75% invested in stocks should draw down a portfolio by 4% or less per year. He felt that retirees who did this had a great chance of making their retirement money last a lifetime. In contrast, he felt that retirees taking 5% annual withdrawals had about a 30% possibility of eventually outliving their money. He put that risk at better than 50% for retirees withdrawing 6-7% per year.

Over time, people began to call Bengen’s dictum the “4% drawdown rule”. The model 4% income distribution could be inflation-adjusted – in year one, 4% of a portfolio could be withdrawn, in year two that 4% withdrawal amount could be sweetened by .03% for 3% inflation, and so on.

A dissenting view. In 2009, William Sharpe (one of the Nobel Prize-winning principals of Modern Portfolio Theory) published an article in the Journal of Investment Management contending that “it is time to replace the 4% rule with approaches better grounded in fundamental economic analysis.” Sharpe thinks that “the 4% rule's approach to spending and investing wastes a significant portion of a retiree's savings and is thus prima facie inefficient.” If a portfolio underperforms, he notes, you have a spending shortfall; and if it surpasses performance expectations, you end up with a “wasted surplus”.

So in Sharpe’s view, by adhering to a 4% rule, you either risk living too large or short-changing yourself. Therefore, it would be better to constantly fine-tune a withdrawal rate according to time horizon and market conditions.

While not necessarily a rule, 4% is a frequent recommendation. There is some compelling research to support the “4% rule”, and that is why financial advisers often cite it and tell retirees not to withdraw too much.

Would withdrawing 4% of your portfolio annually (with adjustments for inflation) allow you to live well? For some of us, the answer will be yes; others will need to address an income shortfall. As we retire, most of us will want to practice some degree of growth investing. Now may be the right time to talk about it.