4 Percent Rule Facts You Should Know

US News

The 4 percent safe withdrawal rule is an incredibly powerful tool that helps investors crystalize their path toward financial independence. Without this guideline, it would be very difficult for most people to plan for decades of not receiving a steady paycheck. However, using this strategy without having a solid understanding of how it works can be dangerous. Here's what you need to know to make the 4 percent rule work for you:

Being able to follow the 4 percent withdrawal rule perfectly is unlikely. Part of the appeal of the safe withdrawal rate is that it is a strategy you can set and forget. You withdraw 4 percent of your retirement assets the first year and an inflation-adjusted amount every year after that. But can anybody actually stick to the same strategy for 30 years without ever deviating from plan? This withdrawal strategy asks retirees to blindly withdraw an inflation-adjusted amount even when the market tanks and soars. Not everyone will have the commitment to stick to the plan under all market conditions. Conservative investors might want to withdraw less or skip the inflation adjustment during bear markets to help the portfolio recover, and it's certainly tempting to take out a little extra when the stock market is booming.

You might have a lot of left over money if you follow the rule. Withdrawing 4 percent each year isn't the average sustainable distribution rate, but the lowest fail-safe rate meant to deal with the worst case scenario for a 30-year investment period. For most starting periods, withdrawing 5 percent or even 6 percent would have been plenty safe, and would give you more to spend on a better retirement lifestyle. And if you don't live 30 years, perhaps a considerable amount of your savings will be passed on to heirs instead of funding your retirement dreams. But the 4 percent rule is meant to provide a safe withdrawal rate during all stock market conditions in case you do live 30 more years in retirement.

There are no guarantees your nest egg will last a lifetime. If you develop a sudden health problem or need a significant home or car repair, you might need to dip into your retirement stash for an amount that exceeds 4 percent. But even if you never withdraw anything from your stash, there's always a chance that something catastrophic could wipe out all your paper assets. Let's face it, no withdrawal rate is truly fail proof. It's impossible to eliminate all risks. Aim to stick to a reasonable number and adjust your strategy as needed.

The rule is designed to work over a 30-year period, which will practically never be your timeline. For people who retire in their 60s, the expected lifespan is well within the 30-year window. A 65-year-old retired couple has about an 18 percent chance of either of them reaching 95, which gives them a very small probability of outliving their assets. Some people would say they are almost guaranteed to not run out of money too soon, especially when you factor in the fact that almost everyone will have some form of Social Security and home equity to tap if the worst case scenario actually materializes.

However, early retirees with a longer time horizon may need to play it safe at the beginning of retirement because the 4 percent rule doesn't account for retirement timeframes beyond 30 years. Early retirees may need to be a bit conservative at the onset of retirement and more flexible throughout retirement to help insure their money lasts for the rest of their life.

The 4 percent rule offers insight into the amount retirees can safely spend each year during an unpredictable future without running out of money. But use the numbers only to plan, as following the rule is neither likely nor prudent.

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