The goal is not to run out of money before you die. Photo: Dan Moyle, Flickr.
Continue Reading Below
When planning for retirement, or doing any kind of planning, really, rules of thumb can come in handy. They can quickly give us a sense of whether we're on or off track, or they can suggest what we might need to do to reach a goal. When it comes to figuring out how much we can safely withdraw from our nest egg each year in retirement, a widely used rule of thumb is the 4% rule. It's not quite as perfect as it might seem, though.
4% isn't a one-size-fits-all rule. Image: Pixabay.
Meet the 4% rule
The 4% rule was introduced by financial advisor Bill Bengen in 1994 and made famous in a study by several professors at Trinity University a few years later: It says that you can withdraw 4% of your nest egg in your first year of retirement and then adjust future withdrawals for inflation. This withdrawal strategy should make your money last through 30 years of retirement.
Here's how it works: Imagine that you've socked away $600,000 by the time you retire at age 65. In your first year, you can withdraw 4%, or $24,000. In year two, you'll need to adjust that rate by inflation. Let's say that inflation over the past year was at its long-term historic rate of 3%. You'll now multiply your $24,000 withdrawal by 1.03 and you'll get your second year's withdrawal amount: $24,720.
The 4% rule is helpful in another way, too -- if you want to figure out how big a nest egg you need to accumulate for retirement. Since 1 divided by 4%, or 0.04, is 25, you can multiply your desired income in your first year of retirement by 25. For example, if you estimate that you'll need $30,000 of annual income from your investments in retirement (perhaps complemented by Social Security benefits), you would multiply $30,000 by 25 to arrive at your nest-egg goal: $750,000.
Continue Reading Below
Different people and different situations will require different withdrawals. Image: Pixabay.
So what's wrong with the 4% rule? Well, several things. Let's review them.
It's not 100% trustworthy: The rule is designed to give you a very good chance, but not a 100% guarantee, of making your money last for 30 years. A T. Rowe Price study found that the 4% rule offered a 90% probability that a portfolio made up of 60% stocks and 40% bonds would last for 30 years. That's pretty good, but a 10% failure rate is a bit scary. A Vanguard study found that over 35 years, the rule worked only 71% of the time for a portfolio equally divided between stocks and bonds. It's worth considering 35 years, because some of us may retire early and live a very long time. Retire at 62 and die at 100 and you're looking at a 38-year retirement.
Different portfolios will behave differently: The more heavily weighted with stocks your nest egg is, the more rapidly it will likely be able to grow -- but it will also be more exposed to stock market corrections. The more bonds you have, the more stable your portfolio may be, but it might not grow as briskly. Each of us will have to settle on the mix that seem best for us, adjusting it over time. Applying the 4% rule to lots of different kinds of portfolios will yield lots of different results.
Market volatility make things messy: Then there's market volatility to consider. You might have a nest egg of $600,000 a year before you retire, but what if the market chooses that moment to crash by 10% or 20%? Or what if it crashes and stays depressed soon after you retire? You might have withdrawn $24,000 in year one, but if you take out $24,720 in year two from a nest egg that has shrunk to $500,000, you'll be withdrawing 4.9%, which might shorten its life. Conversely, if the market soars in your retirement's early years, you might be short-changing yourself by taking out a smaller percentage than you could.
Life throws other wrenches in the works, too: Meanwhile, each of our financial lives will play out differently. You may have the perfect retirement plan for yourself and your spouse, but if a child unexpectedly needs financial support or you face some other major financial drain, your plan may no longer be as sound as it was.
Plan well, so that you'll always be able to withdraw ample funds in retirement. Photo:TaxCredits.net .
Hope for the best, plan for less than the best
Clearly, the 4% rule is at least a bit problematic. That's OK, though. You can use it as a starting point and adjust it as you see fit. Or you can use your head and your calculator and you can tap the expertise of advisors to develop your own plan. Here are some strategies to consider:
- If you can afford to play it safe, try to do so. Maybe withdraw less than 4% annually. You might also work a few years longer, to shorten your retirement and let your nest egg grow a bit more. The more conservative you are, the smaller the likelihood that you'll run out of money, but you'll also be more likely to die with a large unspent balance.
- If you're retiring late and expect your retirement to be shorter than most, perhaps withdraw more -- such as 4.5% or 5% annually.
- Take the market's movement into consideration. In a year when the market drops, withdraw less money. In a year when it booms, you might take a little more. Some advise not adjusting your withdrawal for inflation in any year when the market falls or your portfolio shrinks.
- Some experts have suggested never adjusting your withdrawals for inflation, on the assumption that you'll spend less each year over time, growing less active as you age. (It's true that many expenses shrink as we age -- but healthcare expenses often increase.)
- If you find you're withdrawing more than you really need to spend, cut back on your withdrawals.
- Invest your money effectively, to balance risk and reward. Keep a portion in stocks for their growth potential, shrinking that portion as you age. Solid low-cost broad-market index funds to consider include the SPDR S&P 500 ETF , Vanguard Total Stock Market ETF , and Vanguard Total World Stock ETF .
- Look into immediate (not variable or indexed) annuities. For many people, they can provide guaranteed income for life and remove a lot of uncertainty.
At a minimum, reevaluate your withdrawals and the size of your nest egg as you progress through retirement especially in the early years. You want to remain on track to having your money outlast you. Don't be afraid to seek professional advice, either ideally, from a fee-only advisor over one with possible conflicts of interest. Don't rely solely on broad rules of thumb such as the 4% rule.
The article Retirement Planning: Is the 4% Rule the Right Rule of Thumb? originally appeared on Fool.com.
Longtime Fool specialistSelena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright 1995 - 2016 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.