Retirement is an exciting prospect until the time comes for you to consider saving and having adequate financial funds that last as long as you do!
How much do you have for your future? How should you spend and save your money? These are all essential questions when thinking about your retirement fund.
A good rule of thumb to follow when preparing for retirement is the 4% distribution rule. What is it, and how does it work? Let’s discover all about it in this guide.
The 4% Retirement Rule Explained
The 4% retirement rule helps dictate how much you can withdraw and spend annually from your retirement savings. There are of course nuances to this rule, but it helps maintain a sustainable account balance for the years after your retirement.
According to this rule, you can withdraw as much as 4% of your total savings during your first year of retirement – for the succeeding years, you simply adjust depending on inflation.
Background on the 4% Rule
Let’s look at a brief history of the 4% rule. It all started with a Southern Californian financial adviser, Bill Bengen. He created this concept during the mid-1990s using historical data from his bond and stock returns which he collected over a 50-year duration.
Bill Bengen also utilized data from severe market downturns which happened during the 1930s and 1970s. According to him, withdrawing 4% annually from a retirement funds is a safe amount to tryto cover all your expenses.
How Bengen Tested the 4% Rule
Bengen used retirement data from 1926 through 1976. He analyzed the withdrawals made every year and observed the rebalancing of the portfolio in question.
Bengen also examined the longevity of these portfolios. He checked whether someone’s portfolio who retired in 1926 lasted until 1976.
From the results, he discovered that withdrawing 4% initially can help portfolios last for fifty years. For those that did not, the portfolios can still last for at least 35 years.
The Pros and Cons of the 4% Rule
The 4% rule is not a guaranteed regulation that ensures your retirement funds will last forever, but it’s a great suggestion, especially when you want to keep your savings steady.
The rule is easy to follow, and if it really is successful for you, it might protect you from experiencing a funds shortage during your retirement.
As mentioned, it’s not guaranteed, and there are also risks you must be aware of. For instance, the rule is a somewhat dated recommendation. It factored in past market trends, so it’s not 100% certain that it could predict what happens in the future.
Remember that change is constant, and the world continues to evolve. The strategies that worked in the past might not work in the future, especially if market trends and conditions change. For example, bond yields fell very significantly after the 2008/2009 market crash, and the Federal Reserve kept interest rates artificially low for the next 12 years, so that a 4% withdrawal rate on a portfolio that included a good amount of bonds would not have worked too well-you would have eaten up too much of your capital base. The “safe” withdrawal rate for that period of time was more like 2.8%–not 4%!
Moreover, the 4% rule does not include taxes. Let’s say you’re withdrawing $4,000 from your IRA. You must remember that you must also pay state and federal taxes on top of the $4,000. After paying taxes, you are left with a lower amount for spending.
Another possible risk is the mix of investments. The success of the 4% rule also depends on your savings investments. It assumes that you have at least 50% stocks, including a mix of diverse stock index funds.
If you have that kind of mix, then your return can match the overall market, but if your portfolio has a different set-up, you may have a different rate of return. This means you could have a higher or lower amount for withdrawal.
Another disadvantage of the 4% rule is that you need to strictly adhere to it for the entire year. If you violate it and splurge, this can result in various consequences and reduce your principal.
Is Using the 4% Rule Recommended?
If you want a simple guideline to use for your retirement funds, the 4% rule is good enough, but it’s not the best system for everyone. You should consider the following factors:
- The kinds of investments you own
- All your sources of income
- How long you’ll live
- The tax rate you receive after retiring
- The rate of inflation
Don’t forget that your needs might also change every year, especially when you stop working. There is no guarantee that you’ll withdraw the same amount for consecutive years.
Also, by the time you reach 72 years old, the 4% becomes even more useless. It’s the time when you start withdrawing from IRAs or your required minimum distributions (RMDs).
Your RMDs are calculated using a formula requiring you to withdraw more than 4% as you age.
Alternatives to the 4% Rule
If you want more dynamic retirement planning schemes than the 4% rule, you have a wide range of options.
For starters, Boston College’s Center for Retirement Research created a system basing your annual retirement withdrawals on the minimum distribution tables from RMD.
So how does the system work? Your account balance is divided by the distribution period corresponding to your age in the proposed table. This will tell you how much you can withdraw each year.
The Center for Retirement Research calculated a safe 3.13% withdrawal when you reach 65 and a 15.67% withdrawal by the time you reach 100.
Like the 4% rule, there are also risks of changing market conditions in following this rule. Plus, it limits your withdrawals when you’re younger. This means it might be hard to follow when you tend to spend more, but this alternative is more flexible because you can spend earned dividends and interest on top of the recommended percentages.
Another great approach is talking to a financial advisor who is certified in retirement income planning. You can share your savings plans for retirement and your ideal spending habits. An experienced advisor can help you determine the best amount to spend and save every year.
The Bottom Line
The 4% rule was created in the past, factoring in historical market trends and performance. While it can be a good guideline to start saving during retirement, it does not guarantee it will last.
Developing a more personalized withdrawal strategy with professional guidance is the best way to save and plan for your retirement. Consider your investments, how you spend, and the taxes you should account for. Everything is dynamic, and your withdrawal plan should be able to adapt to the constant changes.
Robert Ryerson 