The “4% rule” is a crucial factor in retirement planning, as it helps determine the amount of savings required for retirement. While there are numerous recommendations on how much to save for retirement, the actual amount needed can be ambiguous. The 4% rule clarifies this by providing guidance on the necessary savings amount for retirement.
What is the 4% rule?
The 4% rule is a retirement strategy where retirees can withdraw an amount equal to 4% of their savings during the year of retirement and adjust for inflation each year for the next 30 years. This strategy is considered safe.
The 4% rule is not a strict guideline for retirement income but rather a general suggestion. Several factors affect the safe withdrawal rate, including your risk tolerance, tax rates, the tax status of your portfolio (i.e., the proportion of tax-deferred, taxable, and tax-free assets), and inflation, among others.
The benefit of using this rule is that it is straightforward. Having a clear guideline for spending during retirement simplifies the planning process. However, a possible disadvantage is that the rule’s value may no longer apply when you retire. Additionally, a fixed number does not account for fluctuations in the market, which are likely to occur each year.
Let’s examine the 4% rule further to determine if it can serve as a useful guideline for your retirement planning. We’ll explore whether this rule accounts for the various factors that impact long-term savings and future expenses.
History of the 4% rule
Financial advisor William Bengen tested a new approach in 1994 by analyzing 50 years of stock and bond returns from 1926 to 1976. He found that withdrawing 5 percent annually in retirement was not a safe strategy, contrary to the previous belief.
Bergen conducted an extensive analysis of the past 50 years of market data and concluded that retirees could withdraw 4 percent during their first year of retirement, regardless of the economic conditions, and adjust for inflation in the following years for a period of 30 years.
Bengen utilized a portfolio model comprising of 60 percent equities and 40 percent bonds, and the study was carried out when bond returns were higher due to higher interest rates as compared to the present rates.
What the 4% rule doesn’t account for
While William Bengen and the financial community should be commended for their efforts, it’s important to note that the 4% rule may not be applicable to everyone due to unique individual circumstances. This is not a flaw in the rule or its calculations but rather a limitation of applying a strict rule to long-term financial planning, considering the constantly changing economic landscape.
Here are a few factors that are not taken into account when choosing a set-it-and-forget-it 4% flat withdrawal rate during retirement:
Medical expenses: As we age and retire, we’ll likely face various medical expenses, but it’s challenging to foresee the exact type or cost. Certain medical expenses can be significantly more expensive than others, making it hard to predict overall expenses. Additionally, life expectancy is another crucial factor that affects the feasibility of the 4% rule. The longer you live, the more you’ll require your savings to last.
Market fluctuations: Your retirement years may face economic fluctuations. Withdrawing over 4% annually is advisable in a growing economy, while reducing spending during uncertain times is better. There is no fixed rule for financial management. Keeping a watchful eye on your finances and adjusting your actions accordingly is the best practice.
Personal tax rate: Your personal tax rate is influenced by various factors such as the investment accounts you hold, their size, your income from other sources, deductions, credits, and the state where you reside. These are all important factors to consider.
Should you use the 4% rule?
Does the uncertainty around our individual financial situations make the 4% rule irrelevant? No, it can still be useful with some adjustments based on personal circumstances.
The main idea behind the 4% rule and other financial rules of thumb is to provide a starting point for creating a retirement plan that suits your personal savings and spending needs. While these guidelines are not strict mandates, they do offer a helpful reference to guide your planning process. Keep in mind that there is more to consider when it comes to retirement finances, but these rules can be a useful tool to build off of.
The applicability of the 4% rule depends on the investment of your retirement assets. If you’re saving for retirement in something other than a portfolio consisting primarily of stocks and bonds, the 4% rule may not apply to your holdings. Your portfolio’s allocation between stocks and bonds can affect whether a 4 percent withdrawal rate is appropriate or not. Moreover, the rate that works for you today may not be suitable after 20 or 30 years. It’s important to discuss with your financial advisor to determine the projected withdrawal rate that suits you best.