William P. Bengen and the Origins of the 4% Rule

The 4% rule has become very popular due in part to the FIRE movement. But if you have recently learned about it you probably have a bunch of questions of how it works and where it comes from.

The 4% rule originated from a man named William P. Bengen. In 1994 Bengen published a paper called Diminishing Withdrawal Rates Through Historical Data. This paper is where the 4% rule began. According to the 4% rule you can safely withdraw 4% of your portfolio each year, also adjusting for inflation, for at least 30 years. However today many people believe that the 4% rule is too high of a withdrawal rate.

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History of William P. Bengen

William P. Bengen was financial adviser who is most well known for coming up with the 4% rule. Bengen was born in Brooklyn NY in 1947 and lived to be 72 years old. Between 1987 and 1990 Bengen moved to Southern California where he started his financial career. In 1993 at the age of 46 Bengen received a masters degree in financial planning. In 1994 Bengen’s paper, where the 4% rule originated from, was published.

4% Rule Origin - Diminishing Withdrawal Rates Through Historical Data

"Diminishing Withdrawal Rates Through Historical Data" is the paper where the 4% rule originated from. It was written by Bengen and gave retirees a safer withdrawal rate then what was recommended at the time. Here is a link to Bengen's paper.

Nothing on this website is intended to be investment advice. Please consult a professional before making investment decisions.

The historical returns of the s&p 500 inflation adjusted have been floating around 7% for a very long time. That means if you have $1,000,000 invested in the s&p 500 it should earn you on average and inflation adjusted $70,000 a year. This might make you think that you can withdraw $70,000 a year. 

While in many scenarios you could withdraw $70,000 a year, there are many where you can’t and you would end up running out of money if you tried to do this for 30 years. This is what Bengens paper looked at. Bengen’s paper emphasized that there are changes in the market and inflation rates and that these changes need to be factored in.

But the most valuable part of Bengen’s paper is that he gave a concrete number for what you could withdraw while factoring in changes in the market and inflation. That number was 4.1%, however the 4.1% rule didn’t sound that catchy so he renamed it the 4% rule. Many people call this number the Maximum Safe Withdrawal Rate. 

To get this concrete number he used data from 1926 all the way up until 1994. And he figured out how long portfolios would last based on when they started. The start dates ranged from 1926 to 1976.

But you may be wondering the same thing that I was. He was basically stating that if you retired in 1976 that you would not run out of money over the course of 30 years. But 1976 + 30 = 2006, which is greater than 1994. So how did he get data from the future, this paper was written in 1994. 

Well it turns out that he extrapolated the missing years. He used an average rate of return of 10.3% for stocks, 5.2% for bonds, and 3% for inflation.

Why do market fluctuations change how much you should withdraw?

Imagine the following 2 scenarios. In both you start out with $100 and you withdraw $25 a year. In both scenarios the market falls by 50% and also doubles, the only difference is the order in which it happens. If you didn't withdraw any money then in both scenarios you would end up with $100. But here is what happens when you withdraw money yearly.

Scenario 1
Scenario 2

Both scenarios had the same return over the course of 2 years. Both scenarios also had the same CAGR (Compound Annualized Growth Rate). CAGR is the annual rate of return for our investment from start to finish if it had grown at the same rate each year.

So why do you end up with more in one scenario than in the other? This is because a larger portion of our investments were withdrawn early, so you have less to recover later. Consider the same two scenarios framed a different way.

Scenario 1 you withdrew 50% of your funds the first year and 50% the second year

Scenario 2 you withdrew 12.5% the first year 28.6% the second year

How does the 4% rule work?

Take the total amount that you have saved/invested and multiply it by 0.04. This is how much you can withdraw for the next 30 years. Then each year you adjust for inflation.

Let’s do an example. Say you have 1 million saved. You multiply $1,000,000 * 0.04 = $40,000. So you can withdraw $40,000 the first year. Then the next year comes around. You go online and find out that there has been a 3% inflation rate over the last year. So you multiply $40,000 * 0.03 = $1,200, so you increase your spending by $1,200, which is $41,200. Another way to calculate it is $40,000 * 1.03 = $41,200. Then the next year comes and there has been an inflation rate of 2.9%. So you take the $41,200 * 1.029 = $42,394.

Also the 4% rule does not say that you should withdraw 4% of your savings/investments every year. If you do this you are essentially re applying the 4% rule every year.

Can you reapply the 4% rule?

Technically according to the 4% rule you can. However according to Bengen you shouldnt, or at least you shouldnt drastically re apply the 4% rule.

If your portfolio does good in the earlier years of retirement this is generally thought of as a good thing. And if your portfolio does bad in the beginning then you didn't get lucky. This is Bengen's reasoning for not re applying the 4% rule. It can turn you from one of the lucky people into one of the unlucky people.

But even if you become one of those unlucky people you should still be able to last through retirement. So why did Bengen believe you shouldn't drastically re apply the 4% rule? The reason is that when you are unlucky you may make some bad decisions. And those bad decisions can cause you to deplete your savings.

An example of a bad decision is changing up your asset allocation. When Bengen calculated the 4% rule, he did it using asset allocations that didn't change over time. So if you drastically change your asset allocation then the 4% rule may not apply to you anymore.

Is the 4% rule still relevant?

The following is what I found, but remember to consult with a financial professional before making any major financial decisions. There are three types of criticism that you will find when you look into whether the 4% rule is still relevant today.

The 4% rule is too risky.
The 4% rule is too conservative.
The 4% rule is too simple of a rule for retirement.

The first thing you probably noticed is that the first two criticisms listed seem like complete opposites. However they are both somewhat true. 4% is the maximum Safe Withdrawal Rate that Bengen came up. It is a withdrawal rate that, when using historical data, will last at least 30 years in the worst case scenario. However, Bengen showed in his paper that in most scenarios this number would last far longer than 30 years. So most likely you would die with a sizeable net worth. What the second thing is referring too is that Maximum Safe Withdrawal Rate and that these days a rule of 4% is too high.

In Bengen's paper he recommended an asset allocation of 25% to 50% government bonds and in order for portfolio's to last the full 30 years these bonds were necessary. Fast forward to today and bonds are much less lucrative. And this, the way the bond market has changed, is the reason many believe that the 4% rule is too risky and a lower withdraw rate is more appropriate. If you want to find a more appropriate and up to data Maximum safe withdrawal rate you can find one at the bottom of this article .

Another reason people believe the 4% rule is to risky is because it is based off of historical data. Since his article was written other portfolio simulation methods have grown in popularity in the personal finance world. The most common would be the Monte Carlo Method. Using a Monte Carlo calculator to calculate the success of the 4% rule would result in around a 90% success rate.

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