The four-percent rule for safe withdrawals during retirement: Theory versus reality

Last week, I wrote about the problem with retirement spending: How much should you spend during retirement? If you spend too much, you run the risk of depleting your savings. But if you spend too little, you're sacrificing the opportunity to make the most of your money, to “drink life to the lees”.

One of the guiding principles in retirement planning is that there's a “safe withdrawal rate”, a pace at which you can access your investments so that your nest egg will last for thirty years (or longer).

For simplicity's sake, a lot of folks talk about the “four-percent rule”: Generally speaking, it's safe to withdraw 4% from your investment portfolio every year without risk of running out of money. (This “rule” manifests itself here at Get Rich Slowly when I say that you've reached Financial Independence once you've saved 25x your annual spending — 33x your annual spending if you want to be cautious.)

Today, I want to take a closer look at the four-percent rule for safe withdrawals — then explore why the theory behind it doesn't always mesh well with the reality of our daily lives.

The Four-Percent Rule Defined

Last August, William Bengen (who first proposed the 4% rule in a 1994 article), participated in an “ask me anything” discussion at the financial independence subreddit.

Here's the top question and answer from that thread (with additional formatting for readability):

Question
Is the 4% rule still relevant in today's economy? What safe withdrawal rate would you recommend for someone planning for longer than 30 years of retirement?

Answer
The “4% rule” is actually the “4.5% rule” — I modified it some years ago on the basis of new research.

The 4.5% is the percentage you could “safely” withdraw from a tax-advantaged portfolio (like an IRA, Roth IRA, or 401(k)) the first year of retirement, with the expectation you would live for 30 years in retirement. After the first year, you “throw away” the 4.5% rule and just increase the dollar amount of your withdrawals each year by the prior year's inflation rate. Example: $100,000 in an IRA at retirement. First year withdrawal $4,500. Inflation first year is 10%, so second-year withdrawal would be $4,950.

Now, on to your specific question. I find that the state of the “economy” had little bearing on safe withdrawal rates. Two things count:

• If you encounter a major bear market early in retirement, and/or
• If you experience high inflation during retirement.

Both factors drive the safe withdrawal rate down.

My research is based on data about investments and inflation going back to 1926. I test the withdrawal rates for retirement dates beginning on the first day of each quarter, beginning with January 1, 1926. The average safe withdrawal rate for all those 200+ retirees is, believe it or not, 7%!

However, if you experience a major bear market early in retirement, as in 1937 or 2000, that drops to 5.25%. Add in heavy inflation, as occurred in the 1970's, and it takes you down to 4.5%. So far, I have not seen any indication that the 4.5% rule will be violated. Both the 2000 and 2007 retirees, who experienced big bear markets early in retirement, appear to be doing OK with 4.5%. However, if we were to encounter a decade or more of high inflation, that might change things.

In my opinion, inflation is the retiree's worst enemy. As your “time horizon” increases beyond 30 years, as you might expect, the safe withdrawal rate decreases. For example for 35 years, I calculated 4.3%; for 40 years, 4.2%; and for 45 years, 4.1%. I have a chart listing all these in a book I wrote in 2006…

If you plan to live forever, 4% should do it.

That's some helpful information, and it comes directly from a man who has been researching this subject for 25 years. Obviously, it's no guarantee that a four-percent withdrawal rate will hold up in the future, but it's enough for me to continue suggesting that you're financially independent once your savings reaches 25 times your annual spending.

But here's the catch — and the reason I'm writing this article: From my experience, spending in early retirement is not a level thing. It fluctuates from year to year. Sometimes it fluctuates wildly.

The Fundamental Problem with the Four-Percent Rule

Last October at Our Next Life, Tanja wrote that the fundamental problem with the 4% rule for early retirement isn't the 4% rule. “The fundamental problem with any ‘safe' withdrawal rate is the underlying assumption of level spending over time,” she said.

And you don’t have to be planning for dirtbag years followed by larger-living years, as we are, to be looking ahead to increasing costs in the future. You could be the most disciplined budgeter of all time and still need to plan for your spending to change over time.

The problem, Tanja says, is that many costs — especially costs for large expenses — can outpace inflation. Health care costs, for example, have been skyrocketing for years. So has the cost of higher education. Housing costs too have been increasing faster than inflation (and their historical average).

Meanwhile, Social Security and private pensions have not kept pace with inflation. (That's one reason that, like many of you, I don't even consider Social Security when calculating my retirement figures. Yes, I look at my projected benefits now and then. But to me, any future SS payments will be a bonus, not part of my actual calculations.)

For Tanja and Mark at Our Next Life, the solution to this “fundamental problem” is to take a two-phase approach to early retirement.

• The first two decades will be their “dirtbag years”. During this time, they'll have to rely on money from regular, taxable investment accounts. In order to maximize the chances of their money lasting, they plan to live lean. They'll still enjoy life, but they'll do so on a reduced budget.
• Gradually, they'll introduce rental income. Then, when they turn 60, they'll have access to tax-advantaged retirement accounts. (Plus, of course, they should still have some money in taxable accounts.) At this time, they intend to increase their spending.

I like this approach because it builds in the expectation that spending is going to increase as they age — whether they like it or not. Some of this increase will come because they'll get tired of living with less, but some of it will also come from external forces — from inflation, from the costs of health care. I think they're being smart.

My Experience with Early Retirement Spending

From my personal experience, spending during retirement — especially early retirement — hasn't been level. There may be some baseline that you tend toward (like reverting to the mean, basically), but some years you spend a lot, and some years you spend a little.

I look at it as being similar to the stock market. Over the long run, stocks offer a 6.8% real return. That’s their average. But average is not normal. Some years, stocks drop 20%. Other years they’re up 40%. But they’re very rarely at or near 6.8%.

The same concept applies to spending in early retirement.

I achieved Financial Independence in 2009 when I sold Get Rich Slowly. (My income from this site was such that I would have achieved FI in 2011 without the sale. The sale accelerated the process.) Since then, both my spending and income have fluctuated wildly each year.

In 2010, for instance, I earned six figures (yes, despite having sold the blog) but spent very little. I had no mortgage. Kris and I grew a lot of our own food. I worked from home. I hadn't yet succumbed to the travel bug.

My high income continued for a few years, then dropped off sharply. I believe this is why I was audited by the IRS (although you never can be truly certain). For the past few years, I've been lucky to earn $20,000 in a year — although I'm hopeful that I'll earn more now that I've repurchased Get Rich Slowly.

Meanwhile, my spending has been, well, variable.

During 2012, I didn't spend a lot. When Kris and I got divorced, I moved into a cheap apartment and didn't go out much. When I bought my condo in 2013, however, there were plenty of unplanned expenses. While Kim and I were on the road in the RV for fifteen months, our spending was relatively low. But this year? This year, I've spent over $100,000 — and it's only June!

Fortunately, most of this spending is non-consumer in nature — buying back Get Rich Slowly, remodeling the house — but it's still spending. (And the new hot tub? Well, that's 100% consumer spending!)

My Experience with Early Retirement Withdrawals

That's how I spend my money in early retirement. But how do I actually get the cash to spend? How do I convert it from investment accounts to my checking account? That too tends to vary.

In the early years when I was still earning a lot of money, I didn't need to draw on my investment portfolio. My spending was funded by my income, just like it always had been. (And I had money leftover to add to my stash!)

After my income dried up, I had to change my approach. I had to start tapping my investment accounts. I haven't tried to optimize this process (although I probably should). All I do is cash out large “lump sums” of mutual funds.

Generally speaking, I try to maintain a balance in my checking account of between $10,000 and $20,000. That's my “working capital”, I guess. When my balance drops below $5000, I look at my anticipated expenses for the next 6-12 months, then cash out one mutual fund or another.

I also find that I have to redeem shares when I have large one-time expenses.

• Buying a condo? Time to sell.
• Buying an RV? Time to sell.
• Buying back Get Rich Slowly? Time to sell.

There's a huge downside to this approach. Every time I sell shares from a mutual fund, I take a tax hit. This tax hit is pretty low (the 15% long-term capital gains rate), but it still stings.

Last year, I decided I wanted to try a different approach. Instead of making lump-sum withdrawals, I wanted a steady, reliable source of income. I met with my investment advisor. He and I restructured how my accounts work. Instead of reinvesting interest and dividends, my mutual funds now kick out money into a cash account.

I haven't been using this new approach long enough — and I've continued to have huge expenses — so I'm not sure what the actual implications are. My guess (based on the assumptions my planner and I made) is that my taxable investment account will supply around $15,000 per year. Combined with my income from other sources, this will be enough to cover day-to-day expenses, but I'll still have to cash out lump sums anytime I have a major unexpected expense.

Because I don't want to take the lump-sum approach, one of my medium-term financial goals is to build a balance in some sort of cash (or cash-like) account. I want for this to be my source of operational expenses. If things go well at Get Rich Slowly, my income from this site can serve as the funding source for the new account.

How Do YOU Spend in Retirement?

Over the past decade, I've had zero years of earning and spending that I could consider normal. Zero. Some years I've made a lot of money; some years I've made very little. Some years I haven't spent much; some years I've spent a ton. Honestly, it all seems a little insane.

When I look at my current plan and my current situation, however, it feels like the next few years are moving toward some sort of normalcy. I hope so. As fun and exciting as it's been to enjoy all of these adventures — building and selling a business (then buying it back), traveling the U.S. in an RV, buying and renovating an old home — I crave routine. I also long to have a stable monthly budget.

So, that's how I've handled retirement withdrawals and expenses. I look to the four-percent rule as an ideal, but one that hasn't been applicable to my own life. Not yet, anyhow.

But I'm just one guy — and a strange one at that. I'd love to hear from others.

How do you handle investment withdrawals in retirement? And how do you handle expenses? (Or, if you're not retired yet, what's your plan for these things?) Are your expenses level? Do they fluctuate wildly like mine do? What do you do when you need money? Do you automatically withdraw four percent (or some other amount) every year? Do you use only what your accounts kick off in dividends and interest? Do you pull lump sums? What are things like for you?