2 things too many of you get wrong about the 4% rule

In July, I wrote this column about a man who was working with a financial planner and withdrawing 4% from his investment accounts, but it wasn’t enough, and he was wondering whether he should find a new adviser. One big issue the column brought up was this: People frequently misunderstand the 4% rule for various reasons — and if your financial adviser isn’t clearly explaining it to you or telling you alternatives to it, it might be time to switch advisers. (Looking for a financial adviser? You can use this tool to get matched with a financial adviser who might meet your needs here.)

What is the 4% rule?

The 4% rule — developed in 1994 by financial adviser William Bengen — suggests that you start retirement withdrawals at 4% of your assets and annually increase the withdrawals according to what’s happening with inflation, regardless of what’s happened in the stock and bond markets. “The costs for the things we normally buy increase each year, so it makes sense to have a withdrawal strategy that takes that into consideration,” says certified financial planner Curtis Bailey of Quiet Wealth Management. 

Simply put, the 4% rule is considered a safe withdrawal rate, says accredited asset management specialist and accredited investment fiduciary Ted Halpern of Halpern Financial. “You can assume to safely, over the long-run, withdraw 4% per year without running out of money. There will be years where you go into your principal investment, like this year likely, but over the long-run it’s a safe figure,” says Halpern.

Here’s how the 4% rule might look in practice: If the initial portfolio is $1,000,000, then the first-year withdrawal would be $40,000. Now let’s say inflation looked like this: 1%, 2% and then 3%. Based on the 1% inflation, the next year’s withdrawal would then be $40,400 (that’s $40,000 x 1.01); in the subsequent year with 2% inflation, it would increase to $41,208. Finally, it would be $42,444 based on the 3% rate.  

What are the misconceptions about the 4% rule?

There are also two common misconceptions about the 4% rule, pros say. “The first is that the 4% is the total withdrawal—taxes and advisory fees need to be paid as part of the withdrawal,” says Bailey.

But the reality is this, as Charles Schwab clearly lays out: “The rule guides how much to withdraw from your portfolio each year and assumes that taxes or fees, if any, are an expense that you pay out of the money withdrawn. If you withdraw $40,000, and have $5,000 in taxes and fees at year-end, that’s paid from the $40,000 withdrawn.” But that means you’ll need to consider that you may end up with less than you’d thought: “If you’re paying your adviser 1%, this would only leave you 3% for spending and taxes,” says Bailey.

The second big misconception is that 4% is only calculated once, at the start of the first year, and you start at the same amount each year regardless of portfolio value, says Bailey. “Let’s say a family has a total portfolio of $1 million dollars at retirement — the first year’s withdrawal is $40,000,” says Bailey. Assuming 2% inflation, in the second year, you would take out $40,800, which is the original amount with 2% tacked on, and in the third year, you would take out $41,616, which is $40,800 with 2% tacked on. And adds Bailey: “This amount is calculated without taking into account your current portfolio value, regardless of whether it’s up substantially or lower,” says Bailey. 

What are the main criticisms of the 4% rule?

The rule ignores the performance of an individual’s portfolio. Indeed, it assumes you up your spending every year by the rate of inflation — rather than by how your portfolio performed — which may cause issues for some investors. “What happens when you need to replace your furnace or roof? Or what if you want to take a big trip in the third year of retirement? The rule doesn’t offer answers,” says Bailey. 

It also assumes a 30-year time horizon, which depending on your health and other factors may not be relavant to you. And it is based on calculations that use historical market returns (which may not predict future ones) anda sample portfolio of 50% stocks and 50% bonds.

What else should aspiring retirees consider? 

An important takeaway from the 4% rule is that inflation is at the center of retirement. “It makes sense not only to think about how inflation impacts spending but also how your portfolio is oriented to meet or surpass inflation. Inflation doesn’t care what happened in the markets but your lifestyle does,” says Bailey.

Another thing to consider is taxes. “Taking withdrawals from brokerage accounts may result in smaller overall withdrawals than from a retirement account because you’ve had to pay taxes all along on the brokerage account. An adviser can help you determine what the most advantageous mix of draws are from taxable and non-taxable accounts,” says says certified financial planner Anthony Ogorek of Ogorek Wealth Management.