The One Reason You Shouldn't Trust The 4% Retirement Rule

Regular Money Digest readers will know this isn't the first time we've introduced the topic of the 4% rule for retirement savings. For the uninitiated, the concept of the "4% rule" was first introduced by a financial adviser named Bill Bengen about 30 years ago. The rule stipulates that if retirement savings are withdrawn at a rate of 4% per year, plus later adjustments for inflation, the money will last for at least 30 years or more.

To be clear, the referenced "savings" is actually meant to be an investment portfolio comprising 40% fixed-income assets (like bonds or CDs) and 60% equities (like individual stocks or exchange-traded funds). Per some sources, that formula was later revised to 50% fixed income and 50% equities. If this sounds like a one-size-fits-all approach, it most certainly is.

For that reason, it's unrealistic to expect that 4% (plus inflation) annual withdrawal rate to work for all retirees when cost of living varies drastically in different parts of the country. Similarly, a blanket rate of 4% doesn't account for life changes like medical issues, and assumes that Social Security will remain solvent as a supplement. (For example, here's what will happen to Social Security when Gen X retires.)

However, even in a vacuum where the aforementioned variables don't exist, is the 4% rule good advice? From a purely financial standpoint, the answer leans toward no. A major caveat to the rule exists in the composition and performance of the suggested investment portfolio, which we'll now break down for you.

When you're deciding what percentage of your retirement account to invest in stable fixed-income securities, such as bonds and/or CDs, versus the riskier but potentially more lucrative stock market, a common approach is to use the 100-minus-your-age rule. For example, a 35-year-old investor would hold 65% of their portfolio in equities (100 – 35 = 65%), with the remaining 35% in less volatile fixed-income. Alternatively, a 70 year old would hold a mix of 30% equities and 70% fixed income when using the 100-minus-your-age rule.

The idea is that as an investor gets older and nearer to their retirement age, their risk levels should fall as well. For example, if the stock market experiences a serious correction, or even a crash, there's less time remaining for older investors to recover their losses before needing access to the funds to cover living expenses.

Bill Bengen's 4% rule, on the other hand, specifies a 60-40% (sometimes 50-50%) mix of equities and fixed-income throughout the entire lifetime of the retiree. Yet, that's not a risk level every older investor will be comfortable with. Some retirees don't want to be holding a majority — or even 50% — equities with their retirement date fast approaching. At the same time, younger investors will want to hold more than 50% or 60% equities. That's not to mention portfolio diversification into precious metals like gold, cryptocurrency, and real estate. (See our ultimate guide to investing in gold.)

Finally, note that the 4% rule is predicated on interest income that's generated by fairly high bond yields. While those higher-interest-rate conditions exist today, as well as back when the 4% rule was conceived in the 1990s, that may not always be the case. Bond yields were abnormally low for more than a decade following the bursting of the 2008 housing bubble and the Great Recession period that ensued. If interest rates drop again in the future, it may be hard to earn the necessary returns on the fixed-income side of the portfolio that are necessary to make the 4% rule function properly.

In a nutshell, most investing mantras — whether it's the 4% rule for retirement or the 100-minus- your-age for portfolio balancing — should be treated more like a guideline than an absolute because every investor's situation varies slightly. That said, many studies have shown that the 4% rule will deliver as promised. That is, stretching your savings to last for 30 years or more. However, those models are based on past performance of the stock market and nobody knows what lies ahead.

For a more personalized strategy tailored to your individual goals, lifestyle, and risk tolerance, consider meeting with a competent financial adviser instead. But first, check out Money Digest's tips on how to choose the right financial adviser.