Does the 4% Rule still work?
When you consider all of the major transitions in your life (off to college, first job, get married, start a family, buy a home) no other transition is as welcome and feared as your retirement. Does it really have to be that way? Planning for retirement requires us to make assumptions about our life and the world around us. The planning process typically starts with an analysis of our expected sources of retirement income: an investment portfolio, social security, a pension plan, real estate owned, annuities and a possible inheritance. The next steps include the factoring in of our age and expected lifespan, our anticipated spending needs and an annual adjustment for inflation. The result of this work is the calculation of a sustainable withdrawal rate which over the long term will allow us to live comfortably in retirement.
For over twenty-five years many retirees have relied on the commonly known 4% Rule for calculating their own sustainable withdrawal rate. Here is how it works. In the first year of retirement, you withdraw 4% of your portfolio. In the second and each subsequent year you withdraw the first-year dollar amount adjusted for inflation. For example, if you retire with $500,000 in your portfolio, you would withdraw $20,000 in the first year. In year two, with inflation sitting at 2.0%, you would withdraw $20,400. Remember, withdrawal rates are supposed to increase as we age and spend our nest eggs. A good point of reference on this subject is the IRS required minimum distribution guidelines which specify withdrawal rates at different ages including 3.90% (72 years old), 4.36% (75 years old), 5.34% (80 years old) and 6.79% (85 years old). Adherence to the 4% rule for withdrawals together with a balanced asset allocation (50% stocks and 50% bonds/cash) suggests that one would have a low risk (less than 10%) of outliving their savings over a 30-year retirement. Though easy to understand and implement, the 4% Rule has more recently come under increased scrutiny as yields have fallen and equity returns have become more uncertain. The Rule depends, in part, on higher interest rates to generate income and cash flows sufficient in size to minimize the amount of reduction in account principal.
So, does the 4% Rule still work? Yes. However, it was never intended to be a steadfast rule, rather it is best used as a starting point or guide for planning your early retirement account withdrawals. Be flexible. Planning and executing a retirement plan is challenging. What works for friends may not be suitable for you and your circumstances. As our spending needs or the investing environment changes, we must be able to adapt our plans accordingly. Do not make the mistake of implementing an initial withdrawal strategy and think you are forced to always use that approach. In addition to the 4% Rule, there are several other viable strategies, including, fixed dollar amount, fixed percentage and withdrawing only investment earnings (dividends and interest). A more creative approach might be to combine strategies to target specific needs. For example, use an inflation-adjusted strategy (like the 4% Rule) for essentials and withdraw investment earnings for travel and entertainment. Adjust your discretionary spending based on market performance – spend a little less if the market is down and allow yourself to enjoy that great trip if the market rallies. Live your life. Yes, making lifestyle spending changes can be difficult. Do not focus on the challenges of retirement, rather think of all the new opportunities and experiences that you now have the time to properly explore. Lastly, recognize that to be truly happy in retirement takes more than just sensible financial planning. Your new life awaits – go live it!