Here Are the 4% Retirement Rule's Major Flaws

By Maurie Backman Markets

While there's no magic retirement savings number guaranteed to deliver financial security during your senior years, many near-retirees are advised to use the 4% rule to see if they're on the right track. Although the 4% rule has a strong history of success, it's far from perfect. Here are a few major defects to consider.

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How the 4% rule works

The 4% rule was the brainchild of financial advisor William Bengen. Back in 1994, after testing a range of withdrawal rates, Bengen identified 4% as the highest rate that allowed for sustainable withdrawals over a 30-year time frame.

Specifically, the 4% rule dictates that you can start by withdrawing 4% of your savings balance during your first year of retirement. Then, to maintain your buying power, you'll need to adjust withdrawals for inflation going forward. If you stick to this rule, you stand a strong chance of having your savings last for 30 years.

It sounds simple enough in theory. In fact, you can even use the 4% rule to guess how much money you'll need to have saved before you retire. If you take your estimated annual expenses, subtract your anticipated annual Social Security benefits, and multiply that figure by 25, you'll arrive at your retirement savings target.

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For example, let's say you expect to need $60,000 a year in retirement income but have an estimated $24,000 coming your way in annual Social Security benefits. In that case, you'll be responsible for $36,000 a year in expenses. Multiply $36,000 by 25, and you have a $900,000 independent savings goal. That said, you shouldn't get too comfortable with that number, because while the 4% rule has its fair share of fans, it also has its flaws.

Interest rates are at a low

The 4% rule makes the assumption that as a retiree, you'll have a significant chunk of your portfolio in stocks as well as bonds. In fact, while you're better off with a stock-heavy portfolio during your working years, many financial experts agree that a 60% stocks/40% bonds mix is ideal for retirement. And while stocks have historically outperformed bonds in the long run, this strategy still counts on bonds to generate income.

Now back when the 4% rule was established, interest rates were higher, which means that at the time, bonds could do a better job of keeping up with inflation. However, bond rates are at a multidecade low, which means a 40% bond portfolio will have a harder time keeping pace. Furthermore, because we've been stuck in such a low-interest rut, many seniors are shifting less money into bonds, thus exposing themselves to the kind of stock market volatility that can be dangerous during retirement and diminish the effectiveness of the 4% rule in other ways.

We're living longer

The 4% rule is designed to sustain seniors for a 30-year period. And while a 30-year retirement might seem like a pretty generous estimate, some of us are bound to need more than 30 years' worth of income. Since Social Security first began paying benefits in 1940, the average life expectancy for men and women reaching age 65 has increased almost seven years. And while many seniors (unfortunately) won't make it to the 30-year mark in retirement, those who retire early and live till their mid-to-late 90s may need more income than the 4% rule allows for. If you're lucky enough to live a long life but start by withdrawing 4% of your nest egg from the start, you risk running out of funds down the line.

The market might tank -- or overperform

Another drawback of the 4% rule is that it doesn't account for a major market downturn at the worst possible time -- namely, right before you're set to retire. If stock values plummet right before you need to begin withdrawing from savings, you'll wind up in one of two scenarios: You'll either deplete your savings sooner than anticipated or make smaller withdrawals that leave you strapped for cash in the near term.

On the flip side, if the market performs better than expected, sticking to the 4% rule might leave you with a surplus of money at the end of your life. And while some might argue that this is a good problem to face, it means you'll have deprived yourself of that added income while you were young enough to actually enjoy it.

Despite the 4% rule's inherent flaws, it's still a solid starting point for developing a savings goal and withdrawal strategy. The key is to be aware of these limitations and adjust for them as circumstances dictate. This could mean withdrawing less during periods when the market underperforms, or starting out with a 3% or 3.5% withdrawal rate if you expect your retirement to last more than 30 years. As long as you use the 4% rule as a guideline and remain flexible in your adaptations, you'll be in a good position to make your retirement savings last.

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