The 4% safe withdrawal rule is not really a rule, but a general guideline that will result in a retiree’s portfolio outlasting their lifespan, most of the time. This should be true even for an early retiree that has achieved financial independence at a young age, because 4% is usually small enough to mitigate sequence risk, which is the danger that the market will decline soon after you retire. In most scenarios based on historical data, a balanced or aggressive portfolio will grow in perpetuity by withdrawing 4% of the initial balance per year.
The 4% rule does not mean you withdraw 4% of the present balance each year, but rather the initial balance. Typically, an inflation adjustment is included. If you retire with a $1,000,000 portfolio (for example, 80% stocks and 20% bonds), you would withdraw $40,000 in the first year, and if inflation is 2%, $40,800 in the second year, $41,616 in the third year, and so on. If you retired at the start of 2017, in 2017 your portfolio would probably have increased to about $1,175,000, but you would still withdraw $40,000 in the second year (or $40,800 with 2% inflation), not $47,000. You would withdraw the same amount even if it was a bad year for equities and generally, your portfolio would still eventually recover (rather than going to zero).
Historically, there are years where the 4% rule would not have performed well. Most recently, in 2000, but infamously in 1929 as well. The Great Depression was somewhere around an 80–90% decline, so if you retired right before the crash and then withdrew 4% of the initial balance the next year, that would be 20–40% of the decimated balance, leading quite quickly to running out of money. If you were lucky enough to retire in 2009, you saw immense capital gains in the following decade which has resulted in a much higher portfolio value even with annual 4% withdrawals. To account for potential market crashes, some have suggested changing the 4% rule to 3%. Of course, this is even more likely to leave huge amounts of money on the table when you die, which could be left to heirs or charity. Alternately, you could purchase a single premium immediate annuity from an insurance company, using a lump sum from your portfolio. Then, the insurance company will pay a fixed or inflation-adjusted monthly payment for the remainder of your life (“guaranteed income”). Of course, all insurance products have negative expected return, and their purpose is to protect against unlikely but disastrous outcomes. But, one can retire safely with a smaller nest egg when purchasing an annuity as compared with continuing to invest in securities.
If you are receiving other income, such as a pension or Social Security benefits, you can add these to the 4% rule when considering whether you have enough to retire. If your pension and Social Security give you $30,000 per year, but you need $40,000 to live on, then 4% of your portfolio only needs to amount to $10,000, which indicates an initial portfolio value of $250,000.
Vanguard has a piece from August 2012 on the 4% rule, which misses the point in a spectacular fashion. Vanguard complains about declining dividend yields from stocks and interest yields from bonds. Indeed, the average cap-weighted dividend in the U.S. stock market is presently only 1.87%, which is much less than 4%. But, issuing dividends is a boneheaded way for corporations to use excess capital, and in fact, income from interest and dividends is inferior to capital gains from appreciation in share price. A dividend compels you to take income on the corporation’s schedule, but you could simply sell a portion of your equity stake to receive income on your terms. Warren Buffett knows this well, which is why Berkshire Hathaway famously does not issue a dividend. This has fueled a meteoric rise in its Class A share price ($305,505 per share as of this writing) which otherwise would have been attenuated by the issuance of dividends.
Like most market forecasts, the Vanguard report takes part in a practice no better than fortune telling or astrology: predicting future market performance. Vanguard predicted quite pessimistic returns in August 2012… since then, the S&P 500 has doubled. Of course, it could drop by half in the near or distance future, but good luck figuring out when that will happen. Investing for the long haul is far better than trying to predict market returns.
As for timing withdrawals from your portfolio, because the duration you are invested in the market generally correlates positively with returns, anything that increases the duration you are invested is worthwhile. So, rather than taking your annual 4% withdrawal as a lump sum at the start of the year, monthly distributions are preferable, or even weekly if you can do it without fees or penalties. This is the same concept, in reverse, as to why paying a mortgage biweekly results in slightly less interest paid over the life of the mortgage than paying monthly.
Timing of withdrawals should also consider your tax situation. Because income taxes are assessed based on annual income, if you have less income in a certain year you might withdraw more to enjoy a lower tax rate on the realized income. If you need additional money during a year in which your income is already high, you could withdraw from your Roth accounts, but if your income is low, withdrawing from pre-tax retirement accounts or taxable brokerage accounts is more sensible.
In summary, remember that the 4% rule is in relation to the starting balance of the portfolio. This is related to the idea of declining risk with many decades of being invested in the S&P 500, whole U.S. stock market, or whole global stock market. The risk of loss approaches 0% with a longer duration of investment in relation to the initial balance, not the current balance. Consider two people: one invested $1 million in the S&P 500 on September 20, 2018, and another had $1 million in the S&P 500 as of September 20, 2018 that had been invested for 30 years. Both still wound up with a balance of about $800,000 on December 24, 2018, but the latter person still had much more money compared with their initial investment in 1988, even adjusting for inflation.
The 4% rule is an attempt to mitigate both sequence-of-returns risk and longevity risk. Sequence risk is the risk that you retire right before the market crashes, which could put you in the poorhouse. Usually, withdrawing 4% of the initial balance each year is sufficiently low to leave enough money in the portfolio for it to recover, despite the poor performance early in your retirement (although it is always better to withdraw less in such a scenario, if you can manage to do so). Longevity risk is the risk that you outlive your money, and the 4% rule mitigates this by leading you to dying with much more money than you started with when you retired, in most scenarios. Predicting one’s death is risky business… you can’t just look at life expectancy because that’s a median, which means 50% of people live longer than life expectancy. If you time your spending to run out of money right at 79, you might end up living to 99 but you will be destitute for those last 20 years. No one wants that.
