Visualizing the 4% Rule
The 4% rule is a popular retirement income strategy in which retirees withdraw 4% of their initial account balance annually, adjusting the amount for inflation every year thereafter. The purpose of this post is to use the visual domain to explain how this strategy works, and to show how it performed historically.
1. How does it work?
Below is an example of someone retiring with a $1 million in retirement assets in January, 2000. The retiree withdraws 4% of $1 million, $40K, the first year, or $3,333 per month. At the beginning of the next year, January 2001 withdrawals are adjusted for 3.7% inflation in 2000, or $134 per month increase in monthly withdrawals. The assets are invested in a mix of stocks and bonds — in this case 50/50 split between stocks and bonds. The difference between gains and withdrawals is the change in account balance.
As the chart below shows, by 2023 the retiree who has followed the 4% rule with 50/50 stock and bond allocation would have about the same amount of assets they started with, all the while withdrawing real $40K per year. During this time, cumulative withdrawals happened to equal cumulative gains. It is worth noting that even during this period of relatively low inflation, the inflation adjustments account for about quarter of the cumulative withdrawals.
2. How has the strategy performed since 1900?
Since 1900 there have been 88 periods of 35 years to test whether the 4% rule succeeds in not running out of money. The chart below shows that, indeed, there were exactly zero periods where a retiree ran out of money. In fact, in all 88 cases the asset balance at the end of the retirement is much higher than at the beginning. Not surprisingly, the 4% withdrawal rate is considered a safe rate of withdrawal. Even those who retired in January 1929 ended their retirement with more money than they started with.
3. Can we withdraw more?
Probably not. Although there were zero failures with a 5% withdrawal rate, the failures quickly add up as you cross that threshold. You can see this in the gif below. In addition, past performance does not guarantee future results, and the U.S. experience so far may be an anomaly as in other countries safe withdrawal rates are lower than 4%.
4. Does asset allocation matter?
Yes, it does, but the 4% withdrawal rate had worked with a wide range of asset allocation. It failed only once — for a retiree who put 100% into stocks and retired, wait for it, in January 1929! Still, as the gif below shows, adding stocks makes for a lot bumpier ride.
5. Conclusion
The 4% rule is a naïve strategy. Dynamic withdrawals and the inclusion of annuities are likely to lead to better outcomes. Nevertheless, those who would like to develop their intuition behind these strategies by playing further with the data and different parameters can use this interactive visualization.