The 4% Rule is a classic retirement financial strategy designed to help retirees consistently withdraw from their portfolios for living expenses without prematurely depleting their funds.
Definition of the 4% Withdrawal Rule:
In your first year of retirement, withdraw 4% from your portfolio for living expenses; thereafter, adjust this amount annually for inflation to maintain real purchasing power.
For example:
Suppose your investment portfolio at retirement is $1,000,000:
Year 1. First-year withdrawal: $1,000,000 × 4% = $40,000
Year 2. If the inflation rate in the previous year was 3%, your second-year withdrawal would be: $40,000 × 1.03 = $41,200
Year 3. If the inflation rate in the following year is 2.5%, adjust the amount further for inflation: $41,200 × 1.025 = $42,230
And so on.
The theoretical basis for the 4% withdrawal method:
It stems from a 1994 study by William Bengen, who backtested the performance of a stock + bond retirement portfolio against the US market history, including various economic cycles.
The backtest showed that this combination and withdrawal method can sustain a 30-year retirement life, even through market declines and inflationary pressures.
Conditions and Restrictions:
Target Audience: Those planning a 30-year retirement (e.g., retiring at age 65 and living for 30 years);
Portfolio Structure: Based on a diversified portfolio of stocks and bonds, the best-performing allocation in Bengen's research is 60% stocks + 40% bonds;
Inflation Adjustment: The actual amount withdrawn each year is adjusted for inflation. Note that even if the account balance increases significantly, the annual withdrawal amount remains the equivalent of 40,000 at retirement, maintaining the same standard of living;
Tax and Medical Expenses Not Considered: The original model does not account for the after-tax cash flow from withdrawals from pre-tax accounts, large medical expenses, and variable expenses associated with disability in old age;
Risks: If the market is in a prolonged downturn, or if retirement is longer than 30 years (e.g., if retiring early), a 4% withdrawal may be too aggressive; if the market and portfolio perform well, a 4% withdrawal may be too conservative.
Conclusion:
The 4% withdrawal method is a simple and practical starting point suitable for:
Preliminary estimation of whether retirement funds will support planned retirement living;
Building a preliminary retirement budget;
Serving as a foundation for financial planning discussions with advisors.
Example:
Assume: A portfolio of $1,000,000 at the end of 1994, retirement in 1995, and a 4% withdrawal method.
Thirty years later, the account balance is $6.46 million;
The inflation-adjusted equivalent is $3.06 million (in 1994 dollars);
The strong market performance in the early years (1995–1999) laid a good foundation for portfolio growth.
Note: Data is based on the historical performance of the S&P 500 index; inflation is based on the CPI published by the U.S. Bureau of Labor Statistics (BLS); results would vary if the portfolio included bonds.
However, the 4% withdrawal method has significant drawbacks. First, it lacks flexibility. Second, in most cases, retirees are "over-saving," failing to fully utilize their retirement savings and enjoy a more fulfilling retirement. If retirement financial planning is based solely on the 4% withdrawal method, one could also fall into the trap of "over-saving."
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