As I grow closer to retirement, I’ve read many books and articles promoting different ways to manage your income without running out of money. Some people believe in a bucket system, others use income from stock dividends to cover the majority of their needs. One of the most famous income strategies is withdrawing 4% per year.
What is the 4% rule?
Made famous in the 1990s by Bill Bengen, the 4% rule is designed as an easy-to-use plan to cover your costs during retirement while making your money last. He found that using a portfolio consisting of 50% stocks and 50% bonds would normally provide income during a 30-year retirement if you start by withdrawing 4% of your total retirement portfolio value, then increase with the rate of inflation for each subsequent year. For instance, if you had a portfolio of $1M, you would be able to spend $40,000 the first year. If inflation was 2%, you could spend $40,800 in year two.
Does the 4% rule work?
People have been arguing about whether this rule will work since Bengen first reported his findings. Everything from the percentage you first withdraw to the asset allocation of a retiree’s portfolio has been studied and challenged. Some people say a 3.5% rate is the best point at which to begin withdrawals; others say you could consider as much as 5%. Bengen himself recently noted that the 4% rule was a worst-case scenario, and he had bumped up the suggested first year withdrawal to 4.7%.
Is 4% too inflexible?
While having a magic number that would work in all instances would be nice, the inflexibility of a set 4% with an inflation adjustment doesn’t make sense for most people. People who have their essentials covered by Social Security or a pension would probably be able to spend 5% or more per year. Others with a large retirement portfolio who purchase an annuity to cover expenses could go even higher.
Market performance when you retire can also extend or severely curtail your portfolio’s overall performance during retirement. People who must start withdrawals during a down market may see their portfolio’s longevity cut by years, while others in an up market could see their accounts grow by more than their yearly withdrawals.
Deciding on the right amount to withdraw
How long will you live? Like so much with financial planning, it really comes down to the math. How long will you live and how much you have saved will provide a yearly amount you can spend. Of course, no one knows precisely how long they will live. However, if you have a family history of living into your 90s, you should plan to have a long retirement. Conversely, if you are suffering from severe ailments when you retire, you may want to plan for a shorter retirement.
Are you comfortable with half of your account in stocks? Remember that Bengen’s analysis was based on retirees keeping 50% of their portfolios in stocks. Many financial professionals advise against this; target funds also severely reduce the stock percentage of your portfolio as you age. Can you sleep at night if your portfolio takes a hit?
How much of a gambler are you? Bengen’s analysis was based on 90% confidence level, meaning that when he ran projections, 90% of them had money at the end of the 30-year period. While many analysts may point you toward the highest possible level of confidence, others say an 80% level is appropriate for most people.
Are you willing to adjust your standard of living in down markets? I think this is the key question for retirement. If you have visions of two trips to Europe each year, will you be okay sacrificing one or both if the markets tank and you need to withdraw only enough money to cover essentials? Most people do this naturally. Think about recent inflation; when prices started going up, did you look for lower priced alternatives, or possibly combine trips to save on gas? I think most people would continue this behavior in retirement.
Smiling all the way
As analysts have watched retiree spending more closely, they have noticed the smile graph. Essentially, people tend to spend more in retirement at the beginning, when they are taking trips more often or spending more for entertainment and eating out. As they age, people often naturally limit expenditures due to…well, old age. It’s harder to get around, you might not enjoy being in crowds, or you’ve been there, done that. At the end of retirement, healthcare costs often raise your expenditure again. Hence the smile.
As this has become more of the norm, some people suggest you allow yourself to spend more while you’re physically able, believing that in time your expenses will drop. This may be a dangerous slope for those who don’t have a lot saved for retirement, in that they could easily spend too much on the enjoyment phase and not have enough for their advanced years. Definitely look closely at your projected income to determine if this is right for you.
I see the 4% rule as a way of estimating what you might need when you retire. It’s especially helpful if you are more than 10 years out, as the numbers are more nebulous at that point. 4% gives you a starting point to help you determine if you’re saving enough, and a kick to save more if you aren’t happy with what your income projects to be if you withdraw only 4%. As you near retirement, you can tweak the numbers to better reflect your individual needs and goals.
Photo by Mikhail Nilov