Drawing It Down: Tweaking the 4% Rule for Retirement Funds

Editor’s note: This is part 1 of “Drawing It Down,” a four-part series on drawdown strategies for current and future retirees. Future installments will look at risk management, “bucketing,” and dynamic withdrawal strategies.

Planning and preparing for your retirement can be a fun yet challenging proposition. The fun part may involve planning travel, art classes, mountain hikes, and the search for pleasant weather, but the challenge involves one simple premise: don’t outlive your money.

In other words, unless you can live off of interest, dividends, and Social Security, or if you have a defined benefit plan such as a company or municipal pension, you may need to draw down your assets over your retirement years.

The academics have done their studies, and the number-crunchers have sliced and diced the historical data, and several theories exist on how you might wish to draw down your money to make it last a lifetime. 

The 4% Rule of Thumb

One of the most popular and widely referenced drawdown strategies is the 4% rule, which says you can withdraw 4% of your retirement savings in your first year, and increase that percentage each year to adjust for inflation. Although a number of questions have arisen in recent years about whether the strategy still works, it still can be used as a baseline. “It’s a very good starting point if you are planning for the next 30 years,” says Matthew Sadowsky, CRPC, RICP, director of retirement and annuities at TD Ameritrade.

The rule assumes your retirement will last about 30 years, and that you are starting with a balanced portfolio made up of 60% equities and 40% bonds. And, of course, because the rule is forward-looking, it must include assumptions on market returns over the course of your retirement years.

Assumptions Are of Interest

The rule may be a good starting point, but changing market conditions and demographics could mean you might want to take a second look at the 4% rule and determine if it’s still right for you. This is especially true if you believe your personal situation may deviate from the 4% rule’s assumptions. “If you plan to retire when you are 50 or if you have longevity in your family, you might need to consider a smaller withdrawal rate in order to have enough money to last your entire retirement,” Sadowsky says.

And about those changing market conditions? Interest rates may finally be crawling off the zero-bound level, but rates are still low by historical levels. In the mid-90s, when the 4% rule first hit the scene, five-year CDs routinely yielded more than 6%.

“We are in a protracted low interest rate environment. We are still very far from the historical norms, and it is a major pain point,” Sadowsky says. “With the 4% rule, you have to care about the future, not the past,” he says. The 4% rule was developed based on historical market results.

Many believe that the ultra-low interest rate era is far from over, which could throw historical returns out of whack. “If you think that interest rates will not be similar to historical norms and we see increased volatility, that can create problems for the 4% rule,” Sadowsky says.

But Problems are Opportunities, Right?

Investors need not despair. Sure, the 4% rule may need some tweaks in order to adapt it to the realities of today and expectations of the future. But the rule was never designed to be a sure-fire guarantee that your money would outlive you. Arming yourself with information and planning tools, and assessing your future income streams and expenses, can help you determine exactly how and when you should draw down your funds.