The 4% Rule: What's a Safe Withdrawal Rate in Retirement?

It's one of most important questions you face when you retire: How much can you withdraw from savings each year without running out of money too soon— and yet not spend so cautiously you feel you're skimping on retirement?

Unfortunately, it's also a daunting query that many retirees have a hard time answering. And a new study suggests some people are headed toward retirement with assumptions that could be frankly dangerous to their finances.

When Fidelity Investments recently asked just over 1,000 pre-retirees what percentage of savings financial experts suggest they should withdraw annually in retirement, 19% said the recommended figure was 7% to 9% a year. That's an amount most retirement experts would agree puts them at high risk of outliving their nest egg. Even more disconcerting, another 19% of those queried as part of the company's Retirement IQ survey felt they could withdraw even more, 10% to 15% a year, a rate that Fidelity estimates could possibly deplete their savings in less than 10 years. In short, nearly four in 10 of the soon-to-be retirees surveyed had an unrealistic view of how much they could spend from savings each year without jeopardizing their retirement security.

So what's the right answer? Financial pros disagree.

Fidelity suggests limiting yourself to an initial withdrawal of no more than 4% to 5% of savings, and then adjusting the dollar amount each year to maintain purchasing power in the face of inflation. That recommendation is largely in line with the 4% rule, a withdrawal regimen that traces its origins to a 1994 study by now-retired financial planner William Bengen. Essentially, Bengen tested a variety of withdrawal rates using historical rates of returns for stocks and bonds. He found that 4% was the highest withdrawal rate retirees could use if they wanted their money to last at least 30 years, assuming they invested at least 50% of their savings in stocks. The 4% rule quickly became the default withdrawal rate for retirees who wanted to make sure that their retirement nest egg would be around as long as they were.

In recent years, however, a number of experts have challenged this rule, warning that it no longer offers the same level of assurance against running through one's assets that it did in the past. "The problem is that at today's low interest rates bonds can't provide the same level of income they previously did," says Wade Pfau, professor of retirement income at the American College of Financial Services. "That means investors have to rely more on the equity portion of their portfolio to support withdrawals."

Since stock returns are highly volatile—not to mention that some experts predict that average annual stock returns could come in several percentage points lower in the decades ahead than in decades past—retirees who start with an initial 4% withdrawal that's subsequently adjusted for inflation run the risk of seeing their nest egg last, say, only 20 years rather than 30.

Indeed, when Pfau calculates safe withdrawal rates based on today's lower yields—which he updates each month on his Retirement Income Dashboard—he estimates that retirees who want a 90% or so chance that their savings will last 30 years should limit themselves to an inflation-adjusted withdrawal rate of just under 3% rather than 4%. At first glance, a drop of a little more than a percentage point may not seem like that big a deal, but it translates to about a quarter less annual retirement income from savings.

But not everyone is so quick to abandon the 4% rule. Michael Kitces, a partner at Pinnacle Advisory Group in Columbia, Md., who writes frequently about retirement issues in his Nerd's Eye View blog, notes that since the early 1870s (that's right, 1870s, not 1970s) investors have endured a number of "worse case scenarios," or extended periods of low bond yields and anemic stock returns. Still, he points out, there's never been a 30-year period over that time in which a retiree following the 4% rule would have run out of money.

On the contrary, 90% of the time investors following the 4% rule would have ended up with more than the amount they started with, and two-thirds of the time they would have more than double their original principal remaining even after 30 years of inflation-adjusted withdrawals. Based on that record, Kitces believes that a withdrawal rate of 4% "is still reasonable in today's environment."

Given this lack of consensus among retirement experts, how can you arrive at a withdrawal rate that will give you an acceptable level of assurance you won't run out of money, yet still allow you to spend freely enough so you can enjoy the retirement you've worked and saved for?

The first thing to do is recognize that it's unrealistic to expect that you, or any retirement expert for that matter, can identify the ideal withdrawal rate in advance. There are just too many unknowables. The rate of return your investments earn, the path of inflation, how long you live, what your actual spending needs turn out to be—all these factors and more can affect what withdrawal rate will work out the best.

So instead of obsessing about picking the "correct" or "ideal" rate, start with something that's reasonable. People can argue about what is and isn't reasonable. But assuming you want your nest egg to sustain you for 30 years or more, I'd say an initial withdrawal rate in the range of 3% to 4% of savings makes sense.

That said, I think most people will find that a withdrawal rate of 3%, even combined with Social Security, probably won't generate enough retirement income to meet their needs. So as a practical matter, I suspect a withdrawal rate of somewhere around 4% is a more likely target for most retirees. You can go even higher if you like, just remember that the higher you start, the greater your chances of depleting your assets prematurely.

Whatever withdrawal rate you start with, you should be ready to adjust it as needed. For example, if the combination of withdrawals and subpar returns or a big market setback take a big chunk out of your nest egg, you may want to forgo an inflation increase or even scale back the amount you withdraw for a year or two. That will give your nest egg a chance to recover and reduce the risk of running through your assets too soon. On the other hand, if higher-than-anticipated investment returns fatten your account balance, you may want to spend more freely for a few years so you don't end up with more assets than you need in your dotage, along with regrets that you didn't live larger and enjoy yourself more while you had the chance early in retirement.

You can make such adjustments by going every year or so to a retirement tool like T. Rowe Price's Retirement Income Calculator—which you'll find in RealDealRetirement.com's Tools & Calculators section—and plugging in your age, retirement savings balance, how your savings are invested and how much you're spending each year. You can then adjust your spending based on the tool's estimate of how likely it is your savings will sustain you throughout retirement. If you're not comfortable doing this on your own, you can go to an adviser periodically for help with fine tuning your withdrawals.

Bottom line: Considering the inherent uncertainty of the financial markets and the likely variability of your post-career spending needs, it's just not practical to think you can set a withdrawal rate and not deviate from it throughout retirement. But if you start with a withdrawal that's sensible and make prudent adjustments along the way, you'll increase your chances of getting the most out of the retirement savings you have.

Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at walter@realdealretirement.com. Follow Walter on Twitter @RealDealRetire.

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