The 3% rule is a guideline for how much a retiree can withdraw from their retirement savings each year to have a 30 year retirement. The rule states that if you withdraw 3% of your retirement savings each year, adjusted for inflation annually, your money should last for 30 years of retirement. This rule aims to provide a sustainable withdrawal rate that reduces risk of running out of money in retirement.
What is the background of the 3% rule?
The 3% rule was originally proposed in 1994 by financial advisor William Bengen. Based on historical returns of portfolios invested in stocks and bonds, Bengen calculated that a 4% initial withdrawal rate adjusted for inflation had a very high success rate of lasting 30 years. He suggested 4% as a “safe withdrawal rate.”
However, subsequent research showed that using an initial withdrawal rate of 3-3.5% was more prudent given lower expected future returns on investments. The 4% rule also did not account for sequence of returns risk in the first 5-10 years of retirement. As a result, many financial advisors now recommend a 3-3.5% initial withdrawal rate at retirement with inflation adjustments in subsequent years.
How does the 3% rule work?
The 3% rule determines a “safe” amount that can be withdrawn from a retirement portfolio each year. For the rule of thumb to work properly, the withdrawals must meet these criteria:
- Withdrawals are capped at 3% of the total portfolio value in the first year of retirement
- The withdrawal amount is adjusted for inflation each subsequent year
- The portfolio is rebalanced annually to maintain the target asset allocation
Here is an example of how a $1 million retirement portfolio would be withdrawn using the 3% rule:
| Year | Beginning Portfolio Balance | Withdrawal Amount (3%) |
| 1 | $1,000,000 | $30,000 |
| 2 | $970,000 | $30,900 (3% of $1,030,000) |
| 3 | $939,100 | $31,836 (3% of $1,061,200) |
This shows how the annual withdrawal is adjusted upwards each year for inflation, assumed to be 3% in this example. The total portfolio balance declines over time as money is withdrawn each year.
What are the pros of using the 3% rule?
Here are some of the key benefits of using the 3% rule for retirement withdrawals:
- High success rate – Historical data shows the 3% rule has about a 90% success rate over a 30 year retirement.
- Accounts for inflation – Annual inflation adjustments help maintain purchasing power over time.
- Long-term guidance – The rule provides a reasonable estimate of sustainable spending over a multi-decade retirement.
- Flexibility – Retirees can adjust spending if extremely high or low market returns occur.
- Simplicity – The 3% rule is straightforward to implement and requires little ongoing oversight.
What are the cons of the 3% rule?
Some of the potential downsides of strictly following the 3% rule include:
- Sequence of returns risk – Encountering poor market returns early in retirement increases failure rates.
- No customization – The rule doesn’t account for individual retiree circumstances and preferences.
- Rigid spending – Withdrawal amounts can’t be optimally adjusted for market fluctuations.
- Overly conservative – Healthy retirees with adequate savings may be able to safely withdraw more.
- No bequest motive – The rule is based on the retiree spending all assets over 30 years.
Does the 4% rule or 5% rule work better?
The 4% rule and 5% rule suggest higher initial withdrawal rates from a retirement portfolio. Here is how they compare to the 3% rule:
4% Rule
- Withdraw 4% of initial portfolio value in first year, adjusted for inflation annually
- Originally proposed as the “safe withdrawal rate” by William Bengen
- Somewhat higher failure rate historically compared to 3% rule
- Provides more retirement income but less portfolio longevity
5% Rule
- Withdraw 5% of initial portfolio value in first year, adjusted for inflation annually
- Much less common than 3-4% rule in financial planning
- Significantly higher failure rate based on backtesting
- Should only be used by retirees willing to accept higher risk of running out of money
In general, withdrawing more than 3-4% annually has greater risks. But a higher withdrawal rate may be acceptable for retirees with a shorter time horizon, higher risk tolerance, or more assets saved.
How to supplement the 3% rule in retirement?
The 3% rule provides a good baseline withdrawal amount from retirement savings. But retirees can also supplement this amount from other income sources:
- Social Security – Delay claiming benefits to increase monthly income
- Pensions – Take advantage of pension income if available
- Part-time work – Earn extra income from side jobs if desired
- Reduce spending – Lower expenses to make retirement savings last longer
- Annuitize assets – Use a portion of savings to create guaranteed lifetime income
Having multiple types of retirement income can provide more flexibility in withdrawal strategies. Retirees don’t necessarily have to limit themselves to only withdrawing 3% from savings.
How much do I need in retirement if I follow the 3% rule?
The amount needed in retirement savings to safely withdraw 3% annually depends primarily on two factors:
- Expected annual spending in retirement
- Desired duration of retirement
To determine the required retirement portfolio size, divide the expected first year spending by 0.03 to get the total savings needed. For example:
- If spending is $50,000 in first year of retirement
- Dividing by 3% withdrawal rate (0.03)
- The required portfolio size is $50,000 / 0.03 = $1,666,667
So in this example, a retiree following the 3% rule would need about $1.67 million saved before retirement to safely withdraw $50,000 each year for 30 years.
Calculating required retirement savings
In general, the formula to calculate the retirement savings needed based on first year spending is:
Retirement portfolio needed = Annual spending / 0.03
So if a retiree wants to withdraw $60,000 in their first year, the calculation would be:
$60,000 / 0.03 = $2,000,000
Therefore, this retiree would need $2 million saved in order to safely withdraw $60,000 initially using the 3% rule for 30 years.
How does the 3% rule adapt to today’s low interest rates?
The 3% rule was developed based on historical market returns of about 7-8% for a balanced portfolio of stocks and bonds. However, with interest rates currently low by historical standards, today’s environment of lower expected returns may require modifications to the rule.
Here are some ways the 3% rule could be adapted for the current low interest rate environment:
- Reduce initial withdrawal rate to 2.5-3% – Provides more buffer for lower portfolio returns.
- Use a variable withdrawal rate – Increase/decrease withdrawal amount based on market performance.
- Shorten time horizon – Plan for 25-30 years of withdrawals instead of 30.
- Include annuities – Use portion of assets to create guaranteed lifetime income.
- Limit portfolio to stocks – Maintain higher expected returns by avoiding low bond yields.
In general, today’s retirees may need to be more flexible and conservative than original 3% rule assumptions. But it still can serve as a reasonable starting point for generating retirement income.
How can the 3% rule be used with the bucket strategy?
The bucket strategy involves dividing retirement savings into multiple “buckets” for different time horizons. This complements the 3% rule nicely by providing more flexibility.
For example, savings could be divided into three buckets:
- Cash bucket – 1-2 years of living expenses in cash
- Short-term bucket – 3-5 years of withdrawals invested conservatively
- Long-term bucket – Remaining assets invested more aggressively for growth
Annual withdrawals can be sourced primarily from the cash and short-term buckets to manage volatility. The long-term bucket can remain invested for growth.
This helps cushion against sequence of returns risk in the first 5-10 years. The long-term bucket is used to replenish the short-term bucket as needed. The 3% rule guides the withdrawal amount each year.
Should I follow the 3% rule blindly?
The 3% rule provides a good starting point for generating retirement income, but should not necessarily be followed blindly. Some important considerations include:
- Be flexible – Adjust withdrawals if extremely high or low market returns occur.
- Have backup income – Don’t solely rely on portfolio withdrawals to cover expenses.
- Monitor progress – Check periodically to see if plan is on track.
- Consider health – Adjust for changes in lifespan expectations.
- Update plan – Revisit assumptions and recalculate withdrawal rate as needed.
Blindly sticking to the 3% rule without ongoing checks can be risky. The key is using the rule as a reasonable starting point but adapting as needed based on individual circumstances.
Conclusion
The 3% rule is time-tested guideline for generating retirement income from savings. While not perfect, it provides retirees with a prudent baseline withdrawal strategy. Implementing the rule in a flexible manner and complementing it with other income sources can allow retirees to maximize their chances of investment sustainability.
With life expectancies increasing, today’s retirees need to carefully manage their assets to avoid longevity risk. The 3% rule helps mitigate this risk and prevent premature depletion while still providing adequate income. Overall, the 3% rule remains a robust starting point that, along with ongoing monitoring and adjustments, can successfully guide an enjoyable retirement.