Don't let this happen to you. Image: Flickr userDan Moyle.
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Figuring out how much money you need to save for retirement can be a huge challenge. Trying to anticipate what returns you'll earn on your money after you retire and how your income will match up with unpredictable expenses by necessity requires some guesswork and simplification, and many have turned to a simple guideline known as the 4% retirement rule to help them figure out where to start.
Using the rule, retirees take 4% of their initial retirement nest egg, and then withdraw that amount each year, raising it by the inflation rate in future years. Yet even though it has value, the 4% rule also some shortcomings, especially in the current environment. Let's look at three serious problems with the 4% retirement rule.
1. The 4% retirement rule aims to be a worst-case scenario
At first glance, the idea that the 4% rule gives you a worst-case scenario might seem like a good thing. After all, if the worst possible outcome is to run out of money in retirement, then a rule that's tailored toward eliminating that possibility sounds like exactly the kind of guideline you're looking for.
The problem, however, is that the worst-case scenario almost never happens, and so the 4% rule is needlessly conservative in the minds of many retirement planners. Specifically, unless the markets behave in exactly the worst possible way, then the amount you can withdraw from your portfolio generally can exceed 4% without running out of money. Every dollar left on the table at your death is one that you didn't get to enjoy during your lifetime. For those with heirs to whom they wish to leave a legacy, that shortcoming isn't necessarily as important, but it can nevertheless produce stress that exaggerates the true risks involved.
2. It's hard to generate withdrawable income when interest rates are low.
One benefit of the 4% rule in many investors' eyes is that you can typically get your portfolio to generate the income you withdraw each year. In the past, when rates on savings accounts were typically 4% to 5% and bond rates were in the upper-single-digit percentages, the 4% rule worked well even with a portfolio split evenly between stocks and fixed-income instruments.
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The current environment is much more of a struggle, because many safe fixed-income alternatives pay far less than 4%. To compensate, many investors have moved their portfolios into dividend-paying stocks, accepting higher than normal levels of risk in exchange for finding ways to generate income without having to sell off investments or dip into the principal of fixed-income balances.
There's nothing inherent in the 4% rule that says you can't make such sales or dip into principal, and in fact, it's expected in later years. But most retirees get nervous spending down their nest eggs, so the current low-rate environment presents a huge challenge.
3. Losses in the bond market are possible.
One big reason the 4% rule has worked so well over the past 40 years is that the bond market has generally provided above-average positive returns to investors. In the late 1970s and early 1980s, the bond market struggled under the weight of high inflation and uncertain geopolitical and macroeconomic factors across the globe, and that sent rates to double-digit percentage levels. Since then, rates have trended lower, and that has added capital gains to the generous income payments that bonds have made.
Now, bond rates are low, and many see them having nowhere to go but up. That introduces the potential for capital losses in the bond market. Those who invest in funds to get fixed-income exposure are particularly at risk, because unlike a regular bond, you can't just hold a mutual fund or exchange-traded fund to maturity and get back your principal. The potential for low or negative bond market returns puts that much more pressure on stocks in order for the 4% rule to work.
The 4% retirement rule serves as a useful guide, but it's not perfect. By realizing some of the controversies about the rule, you can make your own refinements that will tailor it to your own particular needs.
The article 3 Serious Problems With the 4% Retirement Rule originally appeared on Fool.com.
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