What is the Four Percent Rule?
The Four Percent Rule is known as the quantity a retiree should withdraw from their retirement account per year. It is meant to be a benchmark that provides individuals with a steady stream of income while maintaining an account balance that keeps income flowing.
Understanding of the Four Percent Rule
The four percent rule assists financial planners in setting a portfolio’s withdrawal rate for their clients. A key driver in determining the rate is one’s life expectancy. As an individual lives longer, they will evidently need a withdrawal rate that can sustain their portfolio for an extended period of time, while also considering the fact that they are more prone to higher medical expenses.
What are Financial Planners?
A financial planner is an investment professional that helps individuals and corporations meet their long-term financial goals by building a portfolio that meets their risk tolerance and objectives.
Financial planners need to secure one or more professional designations – such as the CFP (Certified Financial Planner). They must also undergo appropriate training and possess the right experience to serve clients and achieve their trust when helping make their financial recommendations.
Financial planners are legally obligated to act in the client’s best interests and cannot personally benefit from the management of their portfolio. They must manage the clients’ assets with no concern for their own benefit.
There are various ways financial planners can make money. For example, they can earn commissions, which are payments from companies whose financial instruments are used. Furthermore, financial planners can also earn money by opening accounts for new clients.
How the Four Percent Rule was Created
The four percent rule stems from historical data on stock and bond returns over the span of 50 years, between the periods of 1926-1976. Before the 1990s, many individuals believed that 5% was the appropriate benchmark value that retirees should’ve withdrawn each year.
However, after speculation, many began to wonder whether such a value would suffice. It led to William Bengen, a financial advisor, to conduct an extensive analysis of historical returns during 1994. His research was strongly driven by severe recessions or economic downfalls between the periods of 1930-1970.
After many stress tests, Bengen concluded that even during economic depressions, a 4% withdrawal would not exhaust a retirement portfolio for over 30 years.
How Inflation Affects the Four Percent Rule
In light of inflation, many retirees increase their withdrawal rate to continue to adapt to stimulated economic conditions. By doing so, individuals can effectively match their income to the cost-of-living changes.
When the Four Percent Rule Becomes Ineffective
The following are several scenarios of when the four percent rule is not effective for retirees:
- During a severe market downturn or inflationary period.
- The temptation to splurge on major purchases. A retiree must remain diligent and loyal to their payouts for the four percent rule to work. Irresponsible spending can lead to many consequences in the future. Whereas the principal value decreases, the compound interest received thereby also lessens. By doing so, it would ultimately reduce the likelihood of living a sustainable lifestyle.
A Perspective on the Four Percent Rule
American financial planner Michael Kitces discovered that the four percent rule might be considered slightly conservative. He states that the rule was catered to the worst economic conditions, particularly in 1929, even faring well during the two most recent financial crises.
Nonetheless, safety is a critical aspect for retirees, especially regarding financials. In fact, Kitces mentions that a 4% withdrawal rate may even lead to a large sum of money left over.
CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: