The one thing everyone wants to know about saving for retirement is how much they'll need in order to be financially secure. That's the reason why what's known as the 4% retirement rule has so much appeal to retirement savers: It offers apparent certainty in an uncertain area. However, the simplicity of the rule also makes it dangerous, and right now, there are several reasons why the rule might not work as well as it has in the past. Below, we'll take a closer look at the 4% rule and some small tweaks you can make to get a result that might be more appealing to you.
How the 4% retirement rule works
Continue Reading Below
The 4% rule is designed to make it easy to figure out how much you need to save in your retirement nest egg. In analyzing the history of financial markets, researcher Bill Bengen came to the conclusion that if one took a retirement portfolio balanced 50/50 between stocks and bonds on the day one retired, withdrew 4% of it for their first-year living expenses in retirement, and then took annual withdrawals that increased the first-year amount by the rate of inflation, the portfolio would last 30 years without running out of money.
As an example, say you managed to save $200,000 toward retirement. Under the rule, you could withdraw 4% of that, or $8,000, the first year. Then if inflation ran at 3%, you'd withdraw $8,240 the second year, $8,490 the third year, and so on. The rule says that under every combination of market returns between 1926 and the date of the paper in the mid-1990s, this strategy left a positive balance remaining after 30 years.
For planning purposes, you can use the 4% rule in reverse to determine how much you need to save. For instance, if you want to withdraw $40,000 per year for living expenses, then you'll need a nest egg of $1 million, because 4% of $1 million is $40,000.
Why the 4% retirement rule might not be ideal
As simple as the 4% rule is, there are some reasons why it might not be the perfect solution for investors. Critics point to a number of aspects of the financial markets today that could put a monkey wrench in the success of the 4% rule.
The most critical problem is that balanced portfolios aren't generating nearly as much income as they traditionally have. Part of the virtue of a 50/50 balance between stocks and bonds is that when interest rates on long-term bonds were in the 6% to 8% range, a retirement portfolio could generate most or all of the money necessary to fund withdrawals solely from interest payments. In that light, even modest dividend payments were adequate to hit the withdrawal target without having to sell off any investments or tap into principal. By contrast, long-term rates are now in the 2% to 3% range, which isn't even enough to pay the income share of the bond half of the portfolio, let alone cover income needs from the whole retirement nest egg.
A related point has to do with the future of the bond market and interest rates. For more than 30 years, the bond market has seen rates steadily decline, producing capital gains for bond investors that have made up a substantial portion of their total return. Going forward, there are higher risks of bond markets falling, with rising yields coming at the expense of capital losses that could hurt retirees.
The other criticism of the 4% rule is that it's often too conservative. Because the 4% amount was generated by looking at worst-case scenarios, you'll often have large amounts left over if conditions are anything other than the worst in history. That's not ideal if you want to make the most of your savings.
Is there a better way?
There are refinements you can make to the 4% rule to address some of these concerns, but none of them are perfect. Using individual bonds or bank CDs rather than bond funds can reduce the risk of capital loss in a bond market collapse, although it won't fix the underlying problem of low rates producing insufficient income. Giving more weight to dividend stocks can increase income and provide better chances of capital appreciation, but at the added risk of a stock market decline.
Another approach focuses on how much you withdraw from your nest egg. If you are willing to reduce your withdrawals even minimally during lean years for the markets, then you can take slightly higher withdrawal percentages without adding risk of running out of money. Even the ability to take a temporary 5% to 10% pay cut can increase acceptable withdrawal rates to higher levels in the range of 5% to 6% per year. Other methods allow you to increase withdrawals if favorable market performance lifts the value of your nest egg above projected levels.
There's no way to predict the future, and so any attempt to solve the question of how you can stretch your retirement savings as far as they'll go will necessarily involve risk. However, by knowing the features and limitations of the 4% retirement rule, you can better understand ways to go beyond it to come up with the best possible solution for your own retirement needs.
The $15,834 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $15,834 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after.Simply click here to discover how to learn more about these strategies..
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.