The 4% retirement rule refers to a particular strategy that is used by retirees when they want to use their savings. The rule says that the best strategy when using your retirement savings is to withdraw about 4% of the savings every year, adjusting the sum for inflation every year. According to calculations made by Bill Bengen, who first proposed the rule in 1994, following such a strategy maximizes the odds that your retirement savings will last at least 30 years, while at the same time using as much of savings as it can.
Pros of the 4% Retirement Rule
The biggest advantage of this rule is that it is very simple to follow. A retiree only needs to know the total value of their savings to arrive at the annual sum that they can withdraw under this plan. If your retirement savings are $1,200,000, then you can withdraw 4% of that sum, i.e. $48,000 the first year. The next year you can withdraw $48,000 adjusted for inflation. This simplicity makes it easy for a retiree to use it without having to use the services of a financial analyst.
The strongest advantage of this plan is that it is a tried and tested plan that has been in place for about 2 decades now. Thousands of retirees use this rule to guide them with their spending and withdrawals, and therefore, this is a plan that can actually work.
Cons of the 4% Retirement Rule
The 4% plan is made under some assumptions, which may not always remain valid. For one, it assumes that you have invested in bonds as well as stocks in a 50-50 ratio. For many investors, this may not be correct: some may invest wholly in bonds, and others may just invest only in blue-chip stocks. Therefore, the effectiveness of the plan depends a lot on the type of portfolio you have. For people who have invested only in bonds, the growth of the portfolio is likely to be lesser, and thus they can withdraw much less than the people who have invested more in stocks.
Another disadvantage of this plan is that it does not envisage any unforeseen circumstances. If it so happens that you have to withdraw a larger sum of money due to some unforeseen medical expenses, then you are left with a much smaller principle than what is assumed by the plan. A more conservative plan would allow for unforeseen expenses, but that is not the case with the 4% rule. Therefore, you have to set aside some part of your savings before you apply the 4% rule to it and withdraw money from it.
Overall, we find that the 4% rule is a tried and tested rule that is simple to follow, but comes with some drawbacks. It does not plan for unforeseen expenses, and nor does it apply to everyone. However, it can definitely be taken as a rough guide to the kind of withdrawals you can make from your retirement fund every year.