Consider the following so-called retirement income problem:
"A man is retiring and has saved a lot of money for retirement.
How much money should he withdraw each year from his savings, so that his money will confidently last 30 years"?
If withdrawing too much, the money may not last his lifetime. If withdrawing too little, his hard-earned money is not best utilized to enjoy life.
Published in
Journal of Financial Planning, 1994, financial advisor William P. Bengen provided an answer:
withdraw 4% of the savings in the first year of the retirement and adjust the withdrawals for inflation in future years. Then the chance of not running out of money in 30 years is about 90%.
Mr. Bengen arrived at this conclusion after performing simulations using historical data on stock and bond returns
over the 50-year period from 1926 to 1976, assuming a 50/50
portfolio (50% of the assets invested in stocks and 50% in bonds).
Here is how the 4% rule works. Suppose he has $2 million allocated to generate yearly retirement income. In the first year of retirement he withdraws 4% of that amount, or $80,000. In the second year of retirement, he adjusts his withdrawal amount for inflation. If the inflation rate is 2% in the previous year, he takes out $81,600 for the second year. He continues to take these yearly inflation-adjusted withdrawals over the course of his retirement
for the rest of his life.
The 4% rule is a rule of thumb. It is meant to be used as a general guideline. Due to low interests in bonds,
Morningstar lately did more simulations using recent stock and bond returns and suggested that
a safe starting withdrawal rate be 3.3%, instead of 4%. This is consistent with Schwab's result for a conservative investor.
Schwab further states that the initial safe (with 90% confidence level) withdrawal rate can be 3.4% for a moderate investor
and 3.5% for an aggressive investor.
With the rising bond yields, as of September 2023, Morningstar improved the safe withdrawal rates to 4% for
a diversified portfolio with 20% to 4o% stocks. Note that more stocks may not be better in the distribution phase.