The 4% rule isn’t broken; it is just badly misunderstood

A recent commentary on this site proudly proclaimed the death of the 4 percent rule, but is it truly dead—or just badly misunderstood?

First, though: What is the 4 percent rule, and why would you care if it is dead or alive?

Piggy bank with tape on it
Branko Miokovic | Getty Images

Retirees with savings need a way to decide how much they can reasonably expect to withdraw from those savings without running out of money in their later years. The 4 percent rule is a rule of thumb widely used by financial planners to address this question.

The idea is that retirees with well-diversified portfolios can start by withdrawing 4 percent (actually, it is closer to 4.5 percent) of their holdings—or $4,500 per year for every $100,000 of investments—to allow themselves a cost-of-living increase every year and still be reasonably assured of not outliving their money.

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In arguing that the 4 percent rule is broken, that commentator made the claim that today's low interest rates make it outmoded. He argued instead for "an emerging class of services from tech-savvy investment managers that provide dynamic withdrawal rates using algorithms that look at market performance, balance and term of portfolio, all of which work together to ensure you won't run out of money."


Technology is great, and it enables us to do many things, but it hasn't yet found a way to predict the future—at least not reliably. Sure, the 4 percent rule has its limitations, but so do all rules of thumb. That doesn't make it broken. It's a rule of thumb.

It is worthwhile, though, to take a look at where this rule of thumb comes from. Back in 1994 a financial planner named Bill Bengen read an article in a popular financial magazine claiming that the "safe withdrawal rate" for a retiree was 6 percent.

Bengen wondered if that was, in fact, true. To find out, he ran an analysis using actual retirement periods beginning as early as 1926, along with their actual returns and actual inflation rates.

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What Bengen discovered was that the 6 percent withdrawal rate he had read about failed around 20 percent of the time, but 4.5 percent survived for every one of those periods—even those starting just before the onset of the Great Depression.

Bengen published his analysis, and since then it has been reviewed, updated, backdated and found to be remarkably robust. Not only did the 4.5 percent rule survive every one of those retirement periods, but more than 95 percent of the time, the retirees ended with the same amount of money they had started with.

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When engineers are testing the limits of a material, they will often stress it until it fails in order to better understand just how it fails. Even more interesting than the 4.5 percent rule of thumb, or even its history, is when the failures for larger withdrawal rates occurred and why.

One might think that the worst time to retire would have been just before the 1929 market crash that led to the Great Depression. Yet that was not when the failures happened. The worst year to retire turned out not to be 1929 but 1969, just before the double-digit inflation of the 1970s. It was not low interest rates or even market collapse that doomed retirees, but galloping inflation.

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History may be an imperfect guide, but it can be worth trying to learn from it. Once retirees know what most threatens their security and how they can respond, they are no longer helpless.

Other studies have shown that during periods of high inflation, taking even slightly less than the full cost of living increase can go a long way toward keeping you secure. That may not be painless, but it is a useful piece of information. Knowing it can give us at least a degree of control over our fate.

"Is the 4.5 percent rule perfect? Of course not; it never was. Is it ironclad? Of course not; it never was. It's a rule of thumb. It's a starting point and never was anything else."

Sure, the world has changed over the last 90 years, but that time period does include periods when interest rates were every bit as low as they are today. It includes market crashes, periods of high inflation, deflation, economic collapse, a nuclear missile crisis, a world war, a cold war and countless seemingly intractable crises.

Is the 4.5 percent rule perfect? Of course not; it never was. Is it ironclad? Of course not; it never was. It's a rule of thumb. It's a starting point and never was anything else. It helps us to understand how retirees have fared under a wide range of circumstances and how they can have some control over the outcome.

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Are there other strategies? Of course there are. Can you make other assumptions? Of course you can. Is the world different than it was 90 years ago? Of course it is. Will the world change again over the course of your retirement? Of course it will. There is an old saying, though: "The four most dangerous words for an investor are 'This time it's different.'"

Be wary of programs that pretend to be better at predicting the future and the illusion of precision they deliver. These programs may give very precise answers, but that doesn't make those precise answers accurate—or even particularly useful.

—By David Mendels, special to Mendels is a certified financial planner and director of planning at Creative Financial Concepts, LLC. He serves on the adjunct faculty of New York University and is a past president of the Financial Planning Association of New York.