4 percent rule: theory vs reality

The 4 percent rule is a heuristic that helps determine how much money you can withdraw in retirement each year without running out of funds.

This article aims to provide insight into how your asset allocation can significantly affect your retirement income and provide food for thought so you are not caught off guard.

Four Percent Rule #

The idea is to withdraw 4 percent of your total assets as income in the first year of retirement. This money replaces the income you had while working. Each subsequent year, adjust the withdrawal amount for inflation. By following this formula, you reduce the risk of depleting your retirement funds while still living off the initial principal.

A Quick Example #

• Starting amount = $1,000,000
• Average percent gain for future = 10%
• Years to live = 30
• Percent Withdrawal = 4.00%
• Inflation Rate = 2.00%

For the first year, you could withdraw $40,000 = ($1,000,000 * 0.04).
The balance after the first year would be $1,060,000 = ($1,000,000 * 0.04) + ($1,000,000 * 1.10)

For the second year, you could withdraw $43,248 = ($1,060,000 * (0.04 * 1.02)).
The balance after the second year would be $1,122,752 = ($1,060,000 * (0.04 * 1.02)) + ($1,060,000 * 1.10)

The average lifespan of an American in 2024 is approximately 77 years, with retirement typically at around age 63. Therefore, statistically, you have about 14 years of retirement on average. Thirty years of income should generally suffice.

Customized Calculator #

Here is a calculator to help you model your own situation.

The inputs to this tool take in the following parameters:

• Starting Amount: Amount of capital you are going into retirement with.
• Average percent gain for future: Expected percentage returns for your investments going forward.
• Years to live: Expected duration for which you need this income.
• Percent Withdrawal: Percentage of the balance you want to withdraw every year.
• Inflation Rate: Annual rate of inflation. This adjusts how much more (or less) you can withdraw each year.

The default value for “Average percent gain for future” is 9.58%, the average S&P yearly return from 1993 to 2023. The default value for “Inflation Rate” is 2.53%, the average inflation rate over the same period.

Two Scenarios #

Even Rate of Return #

Assuming a starting amount of $1,000,000 and using the default values, after 30 years, we end with:

• Total interest earned: $5,334,450.43
• Total amount withdrawn: $3,764,971.56
• Total final balance: $2,517,510.87

This scenario assumes even returns over the specified time period, resembling a portfolio with a high percentage of fixed-income assets.

Real-Life Rate of Return #

Using real returns from the S&P 500 for the 30-year period from 1993 to 2023 (assuming a portfolio of 100% equities), starting with $1,000,000, we end with:

• Total interest earned: $3,190,356.65
• Total amount withdrawn: $2,635,862.94
• Total final balance: $1,526,717.71

This reflects approximately 40% less in total gains and approximately 30% less in total income compared to the first scenario, illustrating a significant difference.

Takeaway #

Results heavily depend on your asset mix. A higher proportion of fixed-income or dividend-yielding assets may yield results similar to the first scenario, while a higher equity mix may resemble the second. Understanding your needs is crucial. Increasing equity exposure earlier in life and transitioning to income-generating assets like bonds and dividend stocks as you near retirement.

You can use my custom calculator here. It allows you to change some of the assumptions and test out different scenarios.

Inflation data source here

S&P 500 returns data source here