Unpacking the 4 per cent rule

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Christine Benz is Morningstar's US-based director of personal finance. This article was initially published on the Morningstar US website.

The so-called 4 per cent rule has been in vogue for 20 years now, taking off in popularity since financial planner William Bengen introduced his research in 1994. This rule back tested data to demonstrate that retirees withdrawing 4 per cent of their portfolios per year for 30 years had a low probability of running out of money during their lifetimes.

Several years later, the Trinity study, so named because it was authored by three professors at Trinity University in 1998, looked back at market data and generally corroborated Bengen's findings. The study concluded that retirees using a 3 per cent to 4 per cent withdrawal rate, combined with annual inflation adjustments, had a good chance of not running out of money during a 30-year period.

Some critics, notably William Sharpe and a team of researchers from Stanford, have since assailed the 4 per cent rule as being too simplistic; others have asserted that Bengen's assumptions about asset allocation were too aggressive for many retirees.

Financial planner Michael Kitces has argued in favour of a withdrawal rate that's sensitive to market valuations. More recently, critics have called the 4 per cent rule too ambitious given the feeble return expectations for the bond market as foretold by today's tiny yields.

Although the debate about safe withdrawal rates is alive and well, I'd argue that the 4 per cent rule isn't an unreasonable starting point for retirees and soon-to-be retirees attempting to gauge whether their spending is sustainable.

Importantly, the rule is intuitive--you don't have to be a pocket-protector-wearing owner of a financial calculator to see if your nest egg and spending rate are close to where they need to be. And, to the extent that 4 per cent is a fairly conservative withdrawal rate, it helps shield against the biggest of all risks that retirees face: running out of money during their lifetimes.

That being said, successfully employing the 4 per cent rule requires that you understand the assumptions behind it, including the following.

Where is the money coming from?

When it comes to the 4 per cent rule, "withdrawal rate" is something of a misnomer, because you're not necessarily invading your principal to generate the entire 4 per cent. Instead, the 4 per cent can come from bond and dividend income, capital gains distributed by your managed funds, or selling securities.