What is the 4 Percent Rule in Investing? 3 Important Things to Know

The thought of outliving your retirement savings can be a daunting thought. That's why it is crucial to stick to a proven system when deciding how much cash you can comfortably withdraw from your nest egg annually without putting yourself at financial risk. One popular approach to solving this problem is the 4 percent rule. Many people have heard about the 4 percent rule of thumb, but most don't completely understand what it means or how to make it work for them.

What Exactly is the 4 Percent Rule?

The 4 percent rule became a standard retirement strategy after William Bengen, a financial advisor, conducted a study in 1994. Bengen's research used historical stock market data from 1926 to 1976 and concluded that regardless of how the market performs, taking out 4 percent from a balanced investment portfolio won't wholly deplete available funds for at least 33 years; much longer than the typical retirement. Since this the data range Bengen chose includes two severe market downturns, it is generally believed this money management system is safe. In fact, the rule is also known as SAFEMAX because it is the maximum amount which can be safely removed from a portfolio. 

Bengen later increased the safe percentages from 4 percent to 4.1 percent if you have to pay tax on your withdraws, and 4.5 percent if you don't; but most people continue to call the strategy the 4 percent rule and use the original 4 percent when calculating their withdraws.

Although it's a popular retirement strategy and works for many people, it may not be a suitable solution for everyone. These are three very important caveats you need to be aware of before adopting the four percent rule. 

Three Important Things to Know About the 4 Percent Rule

1. You Have to Practice Discipline

People who choose to follow the 4 percent rule will have to resist the urge to splurge when the market is doing well. This is particularly difficult when you are getting returns which far exceed 4 percent year after year, and you feel that you are cheating yourself by limiting your withdraws. The 4 percent strategy is for the long haul, and the excess returns made during good years will then offset years that experience underperformance. 

2. Certain Types of Portfolio May Not Fit

The data Bengen used for his study was based on the overall performance of the market. That means that if you have about 60 percent invested in a diversified stock portfolio such as an index fund and 40 percent of your money in bonds, then the 4 percent rule should work over the long term. On the other hand, if you hold a lot of high-risk investments, you are in a much more precarious situation, since a downturn may severely limit your ability to make back the money you lost. 

3. Be Aware of the Required Minimum Distribution Penalties

For some investments, such as IRAs, 401(k)s  and others, you may have to withdraw a minimum amount per year or face a substantial excise tax of 50% of the required sum you do not take out. The date when these minimum distribution penalty requirements go into effect depends on the type of investments when you retire, and your current age. You can find more specifics on the IRS website. This may mean that to avoid the penalty, some years you may have to take out more than you planned. 

Although the 4 percent rule is a tool for approximating portfolio withdrawals, it allows one to keep some consistent mental guardrails around a sustainable distribution plan. If you would like to visit with us about a safe, consistent withdrawal solution for your portfolio, please contact us to discuss your options. 

Spiritual Application

There is no shortage of media headlines permeating our senses that preach doom, gloom, and imminent crises. Looking back over the last 5-6 decades, one look at front page stories on financial magazines makes one wonder how the world still turns. While it is true that no amount of financial planning or investment diversification can completely eliminate financial risk, history can still reveal some clues that we can use to prepare us for the future. 

The phrase "history repeats itself" never holds truer when it comes to financial planning. Economic theory teaches us about short and long-term economic business cycles and the predictability of markets following similar patterns as they've done in the past. But, what does this really mean for our everyday lives and behaviors? If we look to the Bible, early on in Genesis 8:22 it reads "As long as the earth remains, there will be planting and harvest, cold and heat, summer and winter, day and night.” God didn't create a world with only one season or environment, but he did create one that follows patterns and operates in order. We can find a sense of order in our financial lives by realizing that consistency is ultimately what creates financial peace and freedom. And, living in that consistency allows us to have an awareness of changing seasons but not be changed by them.

Evergreen Financial Group is a Fee-Only Financial Planning and Investment Firm located in Billings, MT serving clients in Montana, Wyoming and virtually across the country. Evergreen Financial Group specializes in working with Christian families, including young professionals, Current and Future Retirees and Church Staff Members.