The 4-Percent Rule: 3 Reasons to Rethink Your Retirement
Photo:TaxCredits.net via Flickr.
Retirement planning can get complicated in a hurry. To try to simplify the major question of how much you need to save for retirement, many people have gravitated to a simple guideline known as the 4-percent rule. Yet as easy as it is to use this rule, it's critical to understand its underpinnings and how changing conditions can have an impact on its effectiveness. With that in mind, let's take a look at three things that could lead you to reconsider how you use the 4-percent rule in your retirement planning.
The basics of the 4-percent ruleThe original 4-percent rule aimed to answer the question of how much money you could withdraw from your retirement savings and still have confidence that you'd never run out of money. The rule came about from research by Bill Bengen, whose 1994 paper included an analysis of the stock market through both bull and bear markets since 1926. The paper's conclusion was that "assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe."
The 4-percent rule makes it easy to figure out how much money you'll need to save to finance a given level of anticipated expenses in retirement. Take the desired retirement income level, multiply it by 25 (1 divided by 4%), and you have a target for your nest-egg balance.
Couldn't be simpler, right?The appeal of the 4-percent rule is its simplicity. All you have to do is make a single calculation, come up with your withdrawal amount, and then boost it by the inflation rate each year. The analysis showed that even during major events like the Great Depression and the bear market of the mid-1970s, using the rule worked out.
Yet more recently, some experts have pointed to a few reasons why the original 4-percent rule might not work well. They include:
1. Low interest rates make it hard to generate a 4% withdrawal.The 4-percent rule assumes a 50/50 split between stocks and bonds, and while most investors focus on the risk of the stock market, bonds actually play an important role in the success of your retirement planning by providing much-needed liquidity for withdrawals. With rates at extremely low levels right now, retirees face a huge problem in generating income, with Treasuries currently paying insufficient interest to cover their share of a 4% withdrawal. Since few stocks pay dividends of 4% or more, you'll have to sell off assets each year to cover withdrawals, and not everyone likes doing that.
2. Risks of a bond market decline are higher than normal.On a similar point, the fact that interest rates are low makes it more likely than usual that the future course of rates will head higher. That in turn could hurt the value of the bond half of your nest egg, as rising rates cause bond investments to fall in price. Bengen's data included periods of rising interest rates, especially the inflationary period of the late 1970s and early 1980s. Yet that period was followed by an abrupt downward trend in rates that helped bond prices recover relatively quickly. A longer-term rise could cause no problems.
3. Often, you'll end up with huge savings left over.Most people focus on the potential for the 4-percent rule to fail entirely, leaving you penniless. But on the other side of the coin, the 4-percent rule more often results in having large amounts of unspent cash left over at the end of the 30-year period. That might be fine if you want to leave money behind for your heirs, but its conservative nature could lead you to spend less than you'd like in retirement.
What to do insteadMore recent looks at the 4-percent rule have suggested a number of changes you can make to improve on the original. Some suggest a higher withdrawal rate combined with more complicated guidelines that call for potential withdrawal cuts if the markets behave badly, especially early in your retirement. Others advocate different mixes of stocks, bonds, and other investments, some with an eye toward reining in risk to reduce volatility, and some with the idea of boosting stock allocations to encourage growth.
Yet at its simplest, the advice that most experts would agree on is that tailoring a retirement strategy to individual needs requires individualized consideration of all the factors involved. As helpful as the 4-percent rule is in answering the basic question of how much to save, it's only as good as its assumptions, and those who expect to behave differently in retirement will need to make their own personalized adjustments. Learning about the various financial strategies and products to make those adjustments is a good first step toward tailoring the 4-percent rule to your own needs.
The article The 4-Percent Rule: 3 Reasons to Rethink Your Retirement originally appeared on Fool.com.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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 - 2015 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.