For example, on retirement at 60, you have an investment of ₹5 crore. If you withdraw ₹20 lakh every year, or 4% of your portfolio, your money can last you until you turn 90.
A US-based financial advisor William P. Bengen first articulated the 4% withdrawal rate. He looked at historical data of stock and bond markets. He realised that if an individual withdraws 4% every year from the portfolio after retirement, the corpus will last for a minimum of 30 years, irrespective of market conditions.
It is a conservative approach towards making sure your retirement corpus doesn't get exhausted prematurely. When you're saving for retirement, there is also a lot of uncertainty about life expectancy, market performance, and inflation.
All of these have a direct impact on your investments. You need to be careful about how much you withdraw from it every year to meet your expenses.
The 4% rule tries to protect your savings from such factors by inhibiting retirees from withdrawing beyond a certain percentage from their corpus.
There are times when the thumb rule may not work. For example, a severe market downturn can significantly erode the value of equities in a person's portfolio. It may also not work if the retiree is not loyal to the rule every year.