What You Need To Know About the 4% Rule
The 4% rule is often presented as a virtually fail-safe strategy for making sure you don’t run through your savings during retirement. Just withdraw 4% of your nest egg the first year of retirement, increase that dollar amount each year by inflation to preserve your purchasing power, and you have an 80% to 90% assurance that your savings will last at least 30 years. But it’s not quite that straightforward.
To see why, let’s look at an example. Say you retire with $1 million saved. Going by the 4% rule, you would withdraw, $40,000, or 4%, your first year of retirement and then, assuming inflation runs at 2% a year, you’d pull out $40,800 the second year, $41,600 the third, $42,450 the fourth and so on the rest of your life.
Simple and exact, no?
Trouble is, life isn’t so easy and exact. Any number of unforeseen events—most of which you have no control over—can wreak havoc with this straightforward plan.
One such wild card is the market. The 80% to 90% probability that your savings will last 30 or more years if you limit your withdraws to an initial 4% plus inflation assumes your investments will earn a decent return—and that they won’t get clobbered early in retirement.
If you invest in a diversified portfolio that includes a reasonable mix of stocks and bonds—say, a 40% to 60% in stocks and the rest in bonds—chances are good that you’ll get the long-term returns you need. But that still leaves the other threat to your retirement security—namely, a big market downturn early in retirement.
You don’t have to look back very long to find periods when the stock lost 50% or more of its value. That happened between 2000 and 2002 and again between 2007 and 2009. In fact, research shows that these sorts of frightening setbacks may occur more than investment analysts originally thought.
If you’re unfortunate enough to get hit with such a big loss, or even an extended period of weak gains, especially early in retirement, the chances of your retirement savings lasting 30 or more years with 4%-plus-inflation withdrawals can drop from 80% or 90% to 60% or lower.
The reason is that the combination of your withdrawals and investment losses can so deplete the value of your portfolio that you just don’t have enough capital left to repair the damage when the market eventually turns around.
But there’s another way you can run afoul following the 4% rule. If your investments thrive, limiting your withdrawals to an inflation-adjusted 4% could leave you sitting on a big pile of savings late in retirement, possibly more than you had when you retired.
Granted, this may not seem like much of problem. But ending up with a large nest egg late in life could mean that you economized unnecessarily early in retirement, the very time when you probably could have most enjoyed spending some extra dough traveling, trying out new hobbies or other activities or just indulging yourself occasionally.
There are other potential problems with rigidly sticking to the 4% rule. For example, a spike in inflation could increase the size of your withdrawals so much that you run through your portfolio much sooner. Or you may simply find yourself unable to live within the constraints of the rule. Unforeseen expenses may crop up, requiring you to pull more than your scheduled amount each year.
So how, then, can you manage withdrawals from your savings so you don’t run out of money before you run out of time but also don’t end up discovering late in life that you unnecessarily stinted during your prime retirement years?
I wish I could give you a foolproof, easy-to-follow system. But there isn’t one. Research is being done to find better ways of managing withdrawals. One recent proposal, for example, involves a contrarian idea of starting with a modest amount of stocks early in retirement and then gradually increasing your stock stake as you age.
For now, though, my advice is to think of the 4% rule as a guideline, not a regimen to be followed slavishly. I think an initial withdrawal of 4% is reasonable. But if you’re really worried about running through your dough, you can start with a smaller amount, 3.5% or even 3%. If, on the other hand, you’ve got other resources to fall back on—a pension, lots of home equity, generous relatives—you might start with a bit more, 4.5% or even 5%.
Whatever percentage you start with, be flexible about future withdrawals. If the market takes a dive, you may want to forego boosting your withdrawal for inflation, or even reduce it a bit to give your nest egg a better chance to recover when the market rebounds. If your savings pot starts growing quickly because the market goes on a tear, you may use that as a chance to spend a little more and indulge yourself a bit.
Most important, you want to have an ongoing sense of how long, given your portfolio’s value and your current rate of spending, your money is likely to last. You can gauge that by going each year to a good online calculator, such as one of those in my Retirement Toolbox, which can give you the probability of your savings lasting a given amount of time.
No system can predict the ups and downs of the financial markets, not to mention the twists and turns your life may take in retirement. But if you monitor your spending and your portfolio’s value and adjust withdrawals as conditions change, you’ll be doing all you reasonably can do to assure your money lasts.
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at firstname.lastname@example.org.