It is an unfortunate reality of financial planning and investing that retirement is inherently difficult to plan for. The times change, peoples’ circumstances change, and life expectancies change. And on top of all this, what people want and need to save for retirement varies so greatly that it is hard to give blanket retirement saving and withdrawal advice. Enter: the 4% percent rule.
This retirement withdrawal concept was developed as a way to mitigate all of the headaches listed above. But the question is, is it still relevant? And, is it actually helpful in guiding retirees in knowing how much to withdraw from their accounts?
In this article, we will dive into the 4% rule:
- what exactly it advocates for
- what its origins are
- how it works
- when it might be a good idea
- when it might not be a good idea, and more
We will also briefly touch on alternative retirement withdrawal strategies, but will be covering those in more detail in our next post.
What is the 4% Rule?
It is a rule of thumb intended to be used by retirees in determining how much to withdraw from retirement accounts each year. The goal of the 4% rule is to give retirees a steady source of income throughout retirement while eliminating the possibility of running out of money prematurely. The idea is that a retiree should safely be able to withdraw 4% of his or her total retirement income every year for 30 years. The 4% withdrawal rate is adjusted for inflation after the first year.
Let’s better understand the four percent rule, and the thinking behind it. To do so, it is important to discuss how the rule was developed. The 4% rule is based on a study conducted by William Bengen, an investment manager and financial advisor, in 1994.
His study aimed to explore sustainable withdrawal rates for retirement accounts. In doing so, it reviewed stock and bond data and market conditions from a 50 year period from 1926 to 1976. And finally, it applied a series of hypothetical retirement withdrawal scenarios across that period. Of the withdrawal rates he tested, 4% was the highest amount a retiree could withdraw without risking outliving their retirement savings account balance.
As mentioned previously, the 4% rule does account for inflation and allows retirees to increase the amount their annual withdrawal amount based on inflation rates. Some financial advisors advocate for setting a flat increase in withdrawal rates of 2% per year. This happens to be the Federal Reserve’s target inflation rate. Still others favor adjusting withdrawals annually based upon a given year’s inflation rate.
There are pros and cons to both methodologies: a flat increase is predictable, making it easier to plan ahead. And adjusting your rates based on actual inflation is more effective at accounting for real-world circumstances and financial changes.
So, How Does the 4% Rule Apply to You?
Now it’s time to look into when you may want to consider the four percent rule as a viable retirement planning strategy, and when it may be best to go in another direction.
One helpful piece of information to know about the 4% rule is that it’s based on a retirement portfolio makeup of about 60% stocks and 40% bonds. This premise alone should give people planning for retirement an idea of whether or not the 4% rule might work for them.
Is your portfolio makeup far from 60% stocks and 40% bonds? Then it is probably going to be fairly difficult to make the 4% rule fit within your personal finance parameters.
If your portfolio is similar to this makeup, though, there is one other major factor that will help determine whether or not the 4% rule will work for you. One of its essential tenets is the assumption that the retiree’s spending will stay level throughout retirement.
Do you not anticipate any major or sudden changes to your spending level during retirement and your portfolio is roughly 60% stocks and 40% bonds? Then the 4% rule may work for you.
Of course, it is not always possible to predict whether or not there will be major changes to your spending during retirement. The other important caveat to remember is that the 4% rule was developed in 1994.
Interest rates for bonds were much higher in 1994 than they are now. As such, the possibility of investments under-performing and the retiree prematurely running out of funds is much more real than it was in the 1990s or early 2000s. When the rule was developed 4% seemed to be an entirely safe withdrawal rate. Thus, it’s not necessarily unsafe now, but it should be considered with a grain of salt.
When is the 4% Rule Not a Good Strategy?
So, when should you be sure not to consider the four percent rule as a retirement withdrawal strategy?
We have already mentioned a few concerns in adhering too closely to the 4% rule above:
- your financial needs during retirement could shift suddenly and drastically
- market conditions could change making 4% an unrealistic withdrawal rate
- your asset allocation could be such that the 4% rule just isn’t realistic
If any — or all — of these concerns seem like a major red flag to you, then you probably should not put too much stock in the four percent rule.
Do you plan on withdrawing money from your retirement accounts for more than 30 years and want to be entirely sure that you will not run out of money? Then it is probably not wise to adhere too closely to the 4% rule.
The biggest issue is that it does not account for changing market conditions. Automatically adjusting your withdrawal rate for inflation is not always the best option. However, during a financial downturn or recession, it may be necessary to reduce the amount that you withdraw.
Your portfolio’s unique asset allocation can also make the 4% rule unviable. It was developed using the rigid investment breakdown of 60% stocks and 40% bonds mentioned earlier. Therefore, it does not account for the ways in which varied asset allocation might cause investments to perform differently.
Lastly, are you someone who does not plan on spending a consistent amount of money annually throughout retirement? Then the 4% rule will almost certainly not work for you.
Do you plan on being more active during the first ten years of your retirement than the next ten? Then you may want to withdraw more early on.
Do you anticipate spending more money on grandchildren during the latter half of your retirement than the first half? Then you may want to withdraw less early on.
These are all important things to consider before locking yourself into a set rate of retirement withdrawals.
Thinking about Retirement for the Future
In our next post, we will discuss alternative retirement withdrawal strategies, including a review of Roth IRAs, nest egg, tax-deferred accounts, minimum distributions, and more.
There are many schools of thought and strategies out there. As such, it is in your benefit to consider as many options as possible to find the best fit for your personal and financial situation.
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