Retirement Income Planning: The 4% Rule vs The 25X Rule
Embrace retirement income planning with the 4% Rule and the 25X Rule to create and maintain your best years for your future retirement.
What We'll Cover
- The breakdown of the 25X Retirement Rule
- How to apply the 4% Retirement Rule
- Navigating a financial crisis in retirement
- Comparing the past to the recent financial downturns during retirement years
Have you ever wondered how much money you need for retirement? Whether your retirement is years away or just around the corner, it’s important to do retirement income planning throughout your life.
Unfortunately, there isn’t a foolproof way to determine an exact amount because there are so many factors to consider, like:
- What age will you retire?
- What is your life expectancy?
- What does the economy look like when you retire?
- Where will the economy be during your retirement years?
The good news – there are two retirement income planning rules that can help point you in the right direction based on the one thing we can measure – the past.
Both the 25X Rule and the 4% Rule can give you a great starting point to determine what you need to do now to have enough money at retirement, and then what you’ll need to do in retirement to make that money last.
The 25X Retirement Rule for Retirement Income Planning
The 25X Rule states that you’ll need 25X of your annual spending set aside at retirement to retire comfortably.
To start, determine how much you spend in a year. The best way to do this is by looking at your expenses for a month, then multiplying that total number by 12.
For example, if you spend $5,000 per month, then you know you’re spending $60,000 per year. Next, multiply your annual spending of $60,000 by 25 to get your nest egg amount of $1.5 million.
Nest Egg Amount
Flaws with the 25X Rule
The 25X Rule is simple to calculate, but there are some flaws to be aware of. For starters, it doesn’t take inflation into consideration. And with inflation being at historical highs over the past two years, this would definitely throw off your calculations.
Another flaw is that the 25X Rule does not utilize other sources of income you may have in retirement. For example, the majority of retirees will have social security, some will have a pension, and others still may have other forms of income.
While the 25X Rule is a great starting point to determine how much money you need for retirement, our next rule holds a lot more weight for retirement income.
The 4% Rule for Retirement Spending
The 4% Rule, also called the Bengen Rule, was first published in 1994 by financial advisor William P. Bengen in his paper Determining Withdrawal Rates Using Historical Data in the Journal of Financial Planning.
Bengen was able to show that when a retiree withdraws 4% from their retirement account in the first year of retirement, and then adjusts for inflation every year after that, the retiree’s nest egg will last throughout their entire retirement.
When a retiree withdraws 4% of their nest in their first year of retirement, and then adjusts for inflation every year after that first year, the retiree’s money would last through their entire retirement.
How the 4% Rule for Retirement Works
Let’s assume you have $1 million saved when you enter retirement. The 4% Rule states that first year you would withdraw 4% to be used for income, or a $40,000 income. Then in the following years, you would adjust for inflation.
For example, if inflation in year two of retirement is 6%, then your withdrawal would increase to $42,400.
Year 2 Inflation
Year 1 Withdrawal
Year 2 Withdrawal
If in year three inflation was 3%, then you would adjust accordingly to $43,672.
Year 3 Inflation
Year 2 Withdrawal
Year 3 Withdrawal
Although unlikely, if inflation was negative the next year at -2%, then your income would drop to $42,798.
Year 4 Inflation
Year 3 Withdrawal
Year 4 Withdrawal
The Breakdown of the 4% Rule
The 4% Rule for retirement income planning is so widely accepted because it uses 50 years of historical data from 1926 to 1996 to show that even with effects of both inflation and the stock market, an investor’s nest egg would last 50 years into retirement most of the time.
Even in the rare occurrences when someone’s nest egg didn’t last 50 years, it always lasted at least 35 years.
When someone retired any year between 1926 and 1976 and used the 4% Rule, 80% of the time their nest egg lasted 50 years or more and 100% of the time it lasted 35 years or more.
The important thing to remember is Bengen proved that when someone retired any year between 1926 and 1976 and used the 4% Rule, 80% of the time their nest egg lasted 50 years or more and 100% of the time it lasted 35 years or more.
With the average retirement age in the United States at age 64 and the average life expectancy at 77 years old, you can see the 4% Rule leaves plenty of room to have enough income in retirement.
What About the Next Financial Downturn?
Many Americans are concerned about the effects of another economic downturn either right before retirement or even worse — during retirement.
For most people looking at retirement today, they lived through the Savings and Loans Crisis of the late 1980s, the Dot Com Bubble from 2000 - 2002, the Great Recession from 2007 - 2009, COVID-19 and the downturn as recent as 2022-2023.
With that said, Bengen’s study shows the effects of three of the most significant economical disasters between 1926 and 1996 to be used for comparison to modern-day financial disasters:
Bengen’s Three Major Financial Disasters Between 1926 and 1996
*Chart data collected from Bengen’s Paper in the Journal of Financial Planning.
The chart above shows that even during some of the worst financial disasters in the United States’ history, a retiree’s income would have lasted 35 to 50 years in retirement regardless of when they retired.
This means if someone retired right before, or even during the Great Depression, and utilized the 4% Rule, their nest egg would have lasted throughout their retirement. Even during the 1970s, when inflation was at historical highs, someone using the 4% Rule would still have made it through their retirement years.
Now let’s look at the three recent financial disasters over the past 25 years to get a comparison to the modern-day retiree.
Three Major Financial Disasters Between 1996 and 2022
*Chart data collected from macrotrends.net
In comparing both charts above, there are a lot of similarities to the financial disasters from those earlier years to the same ones we’ve experienced more recently. No one knows what tomorrow will look like and it’s always wise to seek out help from a Certified Financial Planner to help navigate you to and through retirement.
- The 25X Rule helps determine how much to have saved at retirement
- The 4% Rule shows how to make your nest egg last through retirement
- Not every rule is foolproof
- Start saving for retirement as soon as possible
Retirement Income Planning FAQs
What Happens if I Use a 5% Rule for Retirement Income Planning?
Although one percent doesn’t seem like a lot, it actually had drastic consequences when applying a 5% withdrawal rate that first year in Bengen’s study. For example, if someone were to retire in the late 1960s or early 1970s, their nest egg would have only lasted 20 years. When going up to 6% withdrawal rate, there were periods of time where the retiree’s nest egg lasted less than 20 years.
What Is Inside the Nest Egg During Retirement?
Bengen recommended using a mixture of 50% stocks and 50% bonds during retirement years. However, many retirees today believe having that much of their nest egg in equities (stocks) during retirement is too risky.
According to Bengen, those who went less than 50% stock mixture did not end up as well in the study as those who had at least 50% of their retirement nest egg in stocks.
In fact, when Bengen modeled the study with a 75% stocks to 25% bonds portfolio, often the nest egg not only outlasted the more conservative mixture, but also outperformed it in terms of growth.
Is the 4% Rule Becoming Outdated?
Many financial professionals agree that 4% may be too aggressive in today’s standards. However, this has a lot to do with people retiring at a much younger age and life expectancy increasing as time goes on. If you find yourself facing a retirement that could last longer than 35 to 50 years, consider dropping to between 3% and 4% for your new retirement income planning rule.
As you’ve learned by now, retirement is not an age, it’s a number.
When using both the 4% Rule and the 25X Rule, take a moment to determine what you want your retirement to look like in the future. Ask yourself what your expenses will be, how much income you’ll need each month, and how many years you’ll be retired.
Once you have your retirement rules calculated, it’s time to create the plan to help you achieve your retirement goals.
Chris “Peach” Petrie is the founder of Money Peach. Money Peach partnered with OneAZ to provide free financial education to members across the state. To learn more about OneAZ’s partnership with Money Peach, click here.
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APR = Annual Percentage Rate