What it means
Retirees face a tricky question: how much can they spend each year without running out of money? Spend too little and they live more frugally than necessary, while spending too much risks exhausting their savings.
The safe withdrawal rate method gives a starting answer by tying annual spending to the size of the portfolio. The method works in two steps.
You choose a withdrawal rate, such as 4%, and apply it to the portfolio's value at the start of retirement to find the first year's spending. In later years you keep the same dollar amount but increase it each year by the rate of inflation, rather than recalculating it from the portfolio's current value.
The 4% figure comes from research by financial planner William Bengen in the 1990s, which looked at historical US stock and bond returns. It found that, for a 30-year retirement, a withdrawal of about 4% of the starting portfolio, adjusted for inflation, would have survived even the worst historical starting years.
Later studies tested it further and reached broadly similar conclusions, with some variation. The method has important limits.
It assumes a particular mix of stocks and bonds, a retirement of about 30 years, and that future returns are no worse than the historical record. Longer retirements, high fees, poor early returns or lower future returns can all mean a lower rate is safer.
Many planners treat it as a guide rather than a rule. They often adjust spending in bad years, use a flexible rate or combine it with other income such as pensions.
The method is also used in reverse to estimate how large a portfolio is needed to fund a desired income. Taxes and costs also change the picture.
A withdrawal from a taxable or tax-deferred account is not all spendable, and investment fees reduce the return the portfolio earns. A planner usually builds the rate on the amount needed after tax and after fees, rather than on the headline figure.
In practice
Real-world examples.
Example
A 62-year-old couple with $1,000,000 in savings applies a 4% rate and plans to withdraw $40,000 in the first year. They then raise that amount in line with inflation each year, adjusting their lifestyle if markets fall sharply. They also plan to delay larger purchases until a good year.
Example
A financial adviser tells a 45-year-old client that her goal of $80,000 a year in retirement would need about $2,000,000, because $80,000 / 0.04 = $2,000,000. The client uses the figure to set her savings plan, working out how much she must save each year to reach it by retirement.
Example
An early retiree at 50 expects a retirement of 40 years or more. Her planner suggests a lower rate, such as 3.5%, because the 4% rule was designed for about 30 years.
Formula
Calculation
First-year withdrawal = Portfolio value x Safe withdrawal rate. Required portfolio = Annual spending / Safe withdrawal rate.
A retiree wants $60,000 a year of spending from savings and uses a 4% rate. The portfolio needed is $60,000 / 0.04 = $1,500,000. If inflation is 3% in the first year, the second-year withdrawal is $60,000 x 1.03 = $61,800, regardless of how the portfolio performed. The check also works backwards: a portfolio of $900,000 at a 4% rate supports $36,000 in the first year, and the same portfolio at a more cautious 3.5% supports $31,500.Case study
Seen in the real world.
Daniel Okoro is a fictional manager who retires at 65 with $900,000 in an investment portfolio. In this illustrative story, he uses a 4% withdrawal rate, so he takes $36,000 in his first year.
In his second year the market falls 15%, and his portfolio drops to about $735,000. A strict application of the method would keep his withdrawals rising with inflation, but his planner suggests trimming discretionary spending slightly until markets recover.
By holding spending close to the plan and avoiding big cuts, Daniel's portfolio recovers over the following years. The illustrative lesson is that the safe withdrawal rate is a starting point, and flexible spending in bad years improves the odds of success. His planner reviews the plan each year and sets a floor and a ceiling for spending, so that he never has to make large changes at once.
Watch out
Common mistakes.
- Treating the 4% rate as a guarantee, when it is based on historical data.
- Recalculating 4% of the portfolio each year, when the method adjusts the first-year dollar amount for inflation.
- Ignoring fees, taxes and the length of retirement, which can all lower the safe rate.
Questions
People also ask.
Where does the 4% rule come from?
It comes from research by William Bengen in the 1990s on historical US market returns over 30-year periods.
Does the rate depend on my retirement length?
Yes, a longer retirement usually calls for a lower rate, and a shorter one allows a higher rate.
How do I use it to set a savings target?
Divide your desired annual spending by the rate, so $50,000 at 4% needs $1,250,000.
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