Opinion: The 4% rule for retirement spending is now the 4.7% rule

Step one: Start from the end or decide how much income you need — and use a 4.7% distribution rate to back into the size of the nest egg that’s needed to generate it. 

Why 4.7% the first year? Because that’s the distribution program financial adviser Bill Bengen thinks will give you a high probability of not outliving your money, based on his seminal 1994 study of past market performance and his revision of that study in 2020.

His original study argued for a 4% distribution the first year and then adjusting for inflation in subsequent years. That procedure became known as “the 4% rule.”

Bengen’s revision takes the work of financial adviser Michael Kitces using the CAPE Ratio (appraising the stock market by current price relative to the past decade’s worth of inflation-adjusted earnings) and combines it with an inflation appraisal. This gives investors more flexibility to take larger distributions under favorable conditions (cheap stocks and tame inflation) and smaller ones when the opposite conditions prevail.

Bengen’s new work says 4.7% is the new “SAFEMAX” withdrawal rate under poor conditions — his word for the most someone can take the first year with a low probability of depleting their nest egg. Take more than 4.7% from your nest egg the first year, according to the new adjustment, and you run the risk of outliving your money. Take less, and you may leave more on the table than you’d like.

Now let’s get down to brass tacks for someone still some distance from retirement: Let’s say you want $20,000 of annual income in today’s dollars your first year in retirement from your investments to supplement Social Security and any pensions you might have.

That means you need around $426,000 in savings and investments, because $20,000 is 4.7% of $426,000. If you want to take $40,000 from your assets, you should probably have $851,000 saved at retirement, and so on.

Here we arrive at the first uncertainty — market conditions may change during retirement and the 4.7% withdrawal rate may make a portfolio adjustment necessary. 

So if stocks tank your first few years of retirement when you start taking distributions and you have a stock-heavy portfolio, you can scuttle your plan.

That’s why Bengen, in a recent interview with MarketWatch, said he is in favor of a new retiree with a balanced allocation cutting their stock exposure by as much as half, to around 30%, given current stock prices and concerns about inflation.

Bengen said: “Protect your nest egg; don’t let it get smashed by a bear market early in retirement.” He continued: “Buy and hold works best for saving for retirement, but doesn’t apply to folks in retirement. . . .We don’t have any historical period over last 100 years which contains such a high CAPE and inflation in this range.”

So take the 4.7%, but tone down your portfolio.

For those not yet retired, the second step is to apply an inflation rate to adjust the distribution dollar value you think you’ll need. An online inflation calculator can help with this.

In other words, the $20,000 you need in our example probably will not have the purchasing power when you retire as it does now. For example, if you’re retiring in, say, 20 years and inflation is 3.5% annually along the way, then about $40,000 will have the purchasing power that $20,000 does now.

That means you’ll need $851,000 in assets (again following the 4.7% distribution rule), not $426,000, to generate a level of income — $40,000 — with the purchasing power that $20,000 has today.

An inflation assumption of 3.5% a year is a higher number compared to the rate of inflation from 1982 up until 2021, which averaged 2.76% according to data from the Minneapolis Fed. But it may be realistic for the next two decades. It may even be low.

So now, after using the 4.7% rule and making an inflation adjustment, you have an idea, however imprecise, of how big a nest egg you need to retire in the fashion you want — $851,000 to generate $40,000 of income starting in 20 years (or the equivalent of $20,000 in purchasing power today).

The third and last step is how to amass that $851,000 in order to generate $40,000 of income in two decades.

Let’s say you’re 45 years old with $100,000 saved. If we assume a 6% return on your investment, that will give you $320,000 in 20 years (not counting taxes or other fees).

So you need another $531,000. Again, assuming a 6% average annual rate of return for the next two decades, that means you have to save around $14,000 per year for 20 years. Any online retirement calculator that can handle compound interest can get you that answer.

Now you have the three basic steps for understanding what you might need to save for retirement:

1. Start with the income you think you’ll need, and back into the amount of money that can generate the income safely using the 4.7% rule.

2. Adjust both your required income and nest egg for an assumed rate of inflation.

3. Use a retirement calculator to figure how much you still need to save to achieve that nest egg.

John Coumarianos is the founder and managing member of Mindful Advisory, LLC in Northvale, N.J.

More: Beating the 4% rule in retirement has become even easier

Plus: How never to outlive your money