The 4% solution

For the last 80 years, the average annual total return of large-capitalization US stocks has been more than 10% per year. Long-term corporate bonds have returned nearly 6% a year.

Assuming that the next 20 to 40 years will generate similar returns, a portfolio that is balanced equally between stocks and bonds might deliver 8% annualized returns during your retirement.

Given these assumptions, you could draw down 8% of your portfolio every year for retirement spending. That would be $40,000 on a $500,000 portfolio. With such a plan, you could live on your investment earnings. You would still have $500,000 of principal for emergencies or long-term-care needs or to leave as an inheritance.

Trap: Such a strategy has serious flaws. In reality, you probably would not enjoy the type of retirement that you assumed you would.

Better: Withdraw 4% — half the amount — to begin your retirement. Then set your withdrawals on autopilot (regardless of market performance) by increasing the dollar amount of your withdrawal each year by the inflation rate to maintain your spending power.


This seemingly logical “8% solution” creates such problems because the 10% stock returns and 6% bond returns mentioned above are long-term averages.

Stocks and bonds don’t produce such regular returns, year after year. The returns of bonds and especially stocks fluctuate, sometimes dramatically.

As recently as 2000, 2001 and 2002, the S&P 500 stock index, which is a common benchmark for the US stock market, lost 9%, 12% and 22%, respectively. Such drops could create a disaster for a withdraw-8%-each-year strategy.

Example: You have a $500,000 portfolio and in year one withdraw 8% ($40,000). The same year, stocks slide sharply, so your total portfolio loses 10% ($50,000). Now, you have $410,000 left.

Withdrawing 8% in year two gives you only $32,800 to spend that year. That could mean a severe cutback in your lifestyle from one year to the next.

Result: A simple 8% withdrawal strategy means that your retirement income will vary — perhaps enormously — from year to year, and you’ll probably deplete your investments before long.

Numbers crunch: A 10% loss in year one means you would need a 31.7% return in year two, if you want to spend $40,000 again and see your portfolio get back to the original $500,000.


If a steady 8% won’t work, why should you choose 4% — rather than something in between — as the ideal way to tap a retirement portfolio? Studies have shown that a 4% initial withdrawal, increased annually to keep pace with inflation, has a high probability of keeping you from running your portfolio down to zero over a 30-year retirement.

These studies generally assume that around half of your portfolio remains in the stock market and that investment returns and inflation will stay within the ranges they’ve displayed over the past 80 years.

Example: From your $500,000 portfolio, you withdraw $20,000 (4% of $500,000) in 2008.

Suppose that the inflation rate in 2008 is 3%. You would increase your withdrawals by 3%, from $20,000 to $20,600, in 2009.

Suppose that inflation kicks up to 4% in 2009. For 2010, you would increase your withdrawal by 4%, from $20,600 to around $21,400.

And so on. Over time, your portfolio withdrawals will reach $25,000, $30,000 and more.

Payoff: You won’t run out of money within 30 years. In most scenarios based on historic results from stocks and bonds, you’ll still have a substantial sum in your portfolio. You’ll also most likely be able to increase spending above the inflation rate in future years.


In addition to how much to tap your portfolio, you need a plan for which assets to withdraw.

Strategy: Tap only your taxable accounts before age 70. Once you pass that point, you’ll probably be required to withdraw specified minimum amounts from your IRA or other retirement accounts. Waiting to tap them provides extended tax deferral, which is the prime reason to save money in an IRA, 401(k), etc., in the first place.

Tactic: Elect to have your interest and dividends paid to you, rather than reinvested. Those payments can make up part of your portfolio withdrawals, cutting the amount of selling you have to do to raise spending money.

Example: As above, you expect to pull $20,000 (4%) from your $500,000 portfolio in 2008. That $500,000 is evenly split between your IRA and your taxable accounts.

In this example, your $250,000 in taxable accounts includes both stocks and bonds. Dividends and interest payments from those securities are, say, $7,500. If you take out $20,000 from taxable accounts in 2008, and $7,500 of that is paid in dividends or interest, another $12,500 must come from selling securities.

One approach is to sell whichever securities have appreciated the most. This “sell-high” strategy lets you “lock in” profits and gives your lagging investments time to catch up.

Another technique is to sell assets that will deliver the greatest tax savings. You might sell securities that have lost value — so there is no capital gains tax due on them — and sell profitable securities with the smallest possible taxable gains.

Bottom line: Selling high probably will yield better investment results, long term. Selling for tax savings is best if you want certain, near-term tax savings.

Going forward: Say you want to withdraw $20,600 in 2009 but only receive $7,100 in dividends or interest income. You would have to sell $13,500 of securities. And so on, each year.

Alternative: Take some or all of the money from your IRA, if this can be done in a low tax bracket.


The situation changes when you pass age 70½. For most tax-deferred accounts, there are required minimum distribution (RMD) rules you must follow.

Therefore, you probably will have to pull money out of your IRA. According to IRS tables, your first-year RMD generally is around 3.7% of your IRA balance. Each year, as your official life expectancy decreases, this percentage increases slightly. It will reach about 5% at age 78, about 6% at 83, etc.

Example: As above, you started with a $250,000 IRA. If you tapped your taxable accounts first, your IRA might have grown to $350,000 by the time RMDs must begin. During the same time, the amount you plan to withdraw from your portfolio may have moved up from $20,000 to $25,000, due to inflation.

Result: If you must take 3.7% of a $350,000 IRA, that’s $12,950. You can spend that amount, plus another $12,050 from your taxable accounts, bringing the total withdrawal to $25,000 for the year.

Again, the $12,050 you take from your taxable accounts can be your interest and dividend income, plus whatever is needed from sales of securities. If you sell the investments that have appreciated the most, you can rebalance your portfolio and bring your asset allocation into line, rejiggering your assets among stocks, bonds, a real estate fund and other asset classes to meet a target allocation for each class.


As a practical matter, you won’t pull exactly $20,600 from your portfolio in a given year, selling exactly $13,500 worth of securities to match $7,100 in interest and dividends. The “4% solution” is merely a guideline.

However, if you start with a withdrawal of around 4% of your portfolio and increase the amount of money withdrawn by a few percent each year, you likely will avoid running short of spending money as you grow older, even in volatile markets.

Related Articles