CAN YOU RELY ON THE 4% RULE IN RETIREMENT?

By in Guest Post, Retirement | 33 comments

Are You Preparing for Retirement?

by, Miranda Marquit, Plutus Award finalist 

One of the most venerable rules of thumb in the world of financial planning is the 4% rule. This rule states that if you only withdraw 4% from your retirement portfolio each year, you should be able to outlive your money.

Retirement Plans

The rule suggests an inflation calculation that averages of 3% each year, and assumes your portfolio will return 7%. This means that if you only withdraw 4%, you shouldn’t ever have to dip into your principal, and your money will essentially last forever.

In order to determine how big your nest egg needs to be with the 4% rule, you start out by figuring out how much you need each year to live on. Take that annual amount you need from your portfolio and divide it by the 0.04 (4%) projected withdrawal rate. One of the easiest calculations is to assume that you need $40,000 a year for a comfortable retirement. Divide 40,000 by 0.04 (4%), and you end up with $1 million. If you need $50,000 to be comfortable, you still need to divide by the 4% withdrawal rate. In this case you need $1.25 million as your target number of invested assets at retirement.

While the 4% rule seems fairly solid, there are some questions about whether or not it is actually reliable. This is because the 4% rule assumes the following:

Steady rate of return: The first assumption is that a portfolio will offer a steady rate of return – usually 7%. Unfortunately, this isn’t always the case. Further, the performance of a portfolio in the first couple of years of retirement makes a big difference in the long-term performance.

If you use the 4% rule during the first years of retirement, and there is a stock market drop (a la 2008), you actually will dip into your principal. This means that there isn’t as much money earning interest and investment returns, so tyour projected returns aren’t as high. Some say that this evens out over the long run, but it might not even out enough. (Barb’s comment, there is research to support the idea that if market returns are negative during your initial years of retirement, your withdrawal amounts will need to be lower throughout your retirement years). Adhering to the 4% rule in this case could cost you later. You either have to withdraw less than 4%, or hope that gains in subsequent years are so huge that they offset the lower principal you now have.

Fixed expenses: Will your costs remain at $40,000 a year during retirement? The 4% rule assumes that your expenses will remain steady throughout retirement. With inflation averaging at 3% per year, it’s likely that your withdrawal amounts will need to increase as well. what happens if rising medical costs, greater than the projected 3% inflation increase, start to drain your wealth? The 4% rule might be inadequate to combat rising costs – especially if your expenses rise during a stock market down cycle.

Taxes: The 4% rule assumes that taxes remain a fixed expense. However, tax rates change regularly, and that could mean that your taxes rise during retirement, and you end up with a bigger bill. You either have to cut back on some of your expenses, withdraw less, or dip into your principal.

Cash Flow Relative to Costs

Instead of focusing on trying to build up a nest egg that will allow you to withdraw 4% of your portfolio each year, some financial experts are starting to encourage you to look at your cash flow, relative to your probable costs.

This approach is about looking at your total assets, including how much you save for retirement, as well as what sort of monthly income you can receive from them. This approach involves considering various sources of income, and comparing income to costs. You either increase your income, or decrease your expenses, as circumstances require.

It’s less about focusing on attaining a certain “magic number” and more about trying to cultivate income streams that can support you later. The 4% rule makes a few assumptions that the recent past tells us may not hold up. If you want to increase the likelihood of outliving your money, you need to focus on cash flow in retirement, and worry less about following the 4% rule of thumb.

Barb’s Comments; Although you may receive some social security payments in retirement, most of your future income is dependent on your saving and investing decisions today. Save heartily, invest wisely, and consider developing additional income streams to carry you through your retirement.

Miranda Marquit is a freelance writer and professional blogger. She writes for numerous publications, online and offline, including her own blog, Planting Money Seeds.

How are you planning for retirement?

    33 Comments

  1. Great post. The 4% rule is just an average based upon outstanding research by fellow fee-only advisor and NAPFA member Bill Bengen. I had the pleasure of listening to Bill discuss this rule at a NAPFA conference. As Miranda says in the post it is a starting point by everyone’s retirement needs will be different. Such real-world issues as non-linear returns, the timing of bear markets, and other issues require that we revisit and reevaluate retirement withdrawals at regular intervals.

    Roger Wohlner

    August 26, 2012

  2. The 4% rule seems like it could be wildly off the mark in a 0% rate environment. There’s no simple, low risk investment that yields that. Anything you do is going to involve evaluating complex risks.

    W at Off-Road Finance

    August 26, 2012

  3. @W I rarely see a retiree that is able to keep their entire portfolio in a simple, low risk investment vehicle and still earn enough via total return on their investments to fund their retirement. While I don’t advocate taking unneccesary risks the reality of living longer is that retirees need to assume a certain amount of risk in their portfolios in order to not outlive their assets.

    Roger Wohlner

    August 26, 2012

  4. We plan on saving much above what we are supposed to. I believe our retirement number is around $4 million. And we also plan on having passive income to support ourselves as well.

    Michelle

    August 26, 2012

  5. @Roger and @Michelle- As you both alleged, the 4% rule is quite risky, as is the hypothesis that your portfolio will earn 4% after inflation. Especially since few retirees hold a portfolio composed predominantly high risk stock investments with the potential to earn an average 7% return. I am a big proponent of TIPS (treasury inflation protected securities) and Government I (inflation) bonds to protect the purchasing power of your cash.

    Barb

    August 26, 2012

  6. My plan for retirement is to use real estate, specifically single family homes. I have a few already that will be paid off by the time I turn 65. Then I can use the cash flow from them for living expenses. Having single family homes also means I can sell one at a time should I need a large lump sum.

    Couple that with retirement accounts invested in dividend paying stocks, and I should be OK.

    cashflowmantra

    August 26, 2012

  7. Thanks for your comments, everyone. Really, you do have to look at your own situation. Rules of thumb aren’t so reliable, especially when there is high volatility, or other unusual situations. And it’s likely that things will be unusual for a while. And I agree with Barb’s comments that, by and large, we have to rely more on our own efforts than on Social Security, or on a company.

    Miranda

    August 26, 2012

  8. The major problem I have with rules of thumb is that people often forget to mention the assumptions. I like that you put them at the beginning 7% return and 3% inflation.

    I run into this problem at work all the time. We are not meeting some metric and then management tells me to find out why. I explain that the assumptions are incorrect. They tell me, “but the calculation says we should be able to do this.”

    People often get stuck on results of equations without understanding where they come from and how vulnerable the results are to the assumptions.

    Carvin

    August 27, 2012

  9. While the assumptions may seem risky, I also think that the rule is a bit misleading. While I may make $40,000 a year now, I believe that my expenses are higher than they will be when I retire. I will no longer have a house payment. I will defenitely not have a car payment. While my medical expenses may increase, I plan on using Medicare if it is still available. I guess we’ve set ourselves up a little better than most as we have rental property that will be creating income during our retirement. Still, while I’d rather err on the side of caution, I don’t think that I’ll need as much money to retire on as many of these retirement caluclators suggest.

    Greg@ClubThrifty

    August 27, 2012

  10. @W- The future is looking more and more difficult to “guestimate” as the present economic situation is quite unique.
    @Carvin, I really appreciate your input. As a Finance Instructor at a major USA university, the reality of all financial scenarios is based on your initial assumptions and inputs. Those assumptions may or may not be accurate. My default plan for retirement is save as much as possible throughout your working life and develop multiple streams of income.

    Barbara Friedberg

    August 27, 2012

  11. @Greg-That’s why it’s so important for one to individually evaluate their own situation. Some folks want to travel or eat out more, others expect to live modestly in retirement. The biggest unknown in my opinion are health care expenses.

    Barbara Friedberg

    August 27, 2012

  12. And, of course, we can’t forget about taxes! I left those out of my assumptions for the sake of simplicity, but some thought also needs to be given to how taxes are likely to impact us in the future. But I like that so many have pointed out that individual situations matter. You really do need to pay attention to your own goals and needs, since, above all, personal finance is PERSONAL. Thanks so much for the great discussion!

    Miranda

    August 27, 2012

  13. As I understand the 4% – It’s (say) $40K on the $1M for first year, but the $40K is permitted to rise with inflation.
    The historical data showed a 10%+ average market return, so, in theory, if that return were linear, no ups/downs, the withdrawals could be higher. I viewed it as 3% inflation, 4% withdrawal, 3% for volatility.

    I believe there are multiple variations to the concept to help the downside risk. “No increase after a down year” is one. This would hurt over the long term, but with 2 of 3 years positive on average, it’s a 1%/yr inflation hit, not major belt tightening.

    I also think there’s a time to consider an immediate annuity. A 70 yr old woman can get 7% right now. A decision to put 1/2 her retirement account into an IA would return $35,000 on the $1M. The remaining $500,000 needs to provide only $5000 the first year, and can be left to grow for quite some time. Maybe at 80, she buys another, this time yielding over 10%.

    (I’m not a fan of using life insurance products as investments, but I view the IA differently.)

    JoeTaxpayer

    August 27, 2012

  14. Miranda,

    Great to see you here! Will you be a regular at Barbara’s site?

    Brent Pittman

    August 27, 2012

  15. Miranda,

    Great to see you here! Will you be a regular at Barbara’s site?

    Brent Pittman

    August 27, 2012

  16. Thanks, Brent 🙂 No, this was just a guest post for today. Maybe I’ll do another guest post in the future, if she’ll have me!

    Miranda

    August 27, 2012

  17. Steady rates of return is a scary proposition. That’s why some people are in love with the Monte Carlo simulators. Instead of projecting one steady stream, it calculates the probability you’ll make it through.

    AverageJoe

    August 27, 2012

  18. I plan on being even more conservative and only withdraw 3% because I don’t think I will need it. I also think I may live longer than 25 years in retirement. I rather err on the conservative side.

    krantcents

    August 27, 2012

  19. Another great option would be to invest a portion of your portfolio into Vanguard Inflation Protected Securities Fund. This is essentially a bond fund.

    I believe that these common rules serve as nothing more than guidelines. Each person’s financial situation demands scrupulous planning and execution to live comfortably in the golden years.

    My dad used to tell me, “Son, you won’t get wrong if you live like a poor when you are not poor”. He is 80 years old, but he lives life of contentment. That’s the key for financial peace and happiness.

    Shilpan

    August 27, 2012

  20. I’ve always wondered about this. Overall, the commonly accepted math makes sense to me. But it would make sense that the market’s performance in the first few years of retirement could effect the rest of your life A LOT. Thanks for the enlightening article.

    femmefrugality

    August 28, 2012

  21. I think it depends on how you expect to live during your retirement years. I hope to still be active and doing some type of work, just not as time consuming as my current job. If this is the case, I think 4% is fine.

    On the other hand, if you don’t want to do anything that could potentially add income, you probably want to step down to 3% for your withdraw rate.

    Zach @ Milk and Honey Money

    August 28, 2012

  22. @Joe- I’ve tried those simulators and they’re interesting. My default advice is this, try to save as much as possible, invest, and live below your means. The future is always unknowable.
    @Krantc-Conservative scenarios give you a bit of wiggle room.
    @Shilpan-I totally agree with your dad. TIPS and I bonds are excellent options to protect your principal savings and guard against the ravages of inflation.
    @Femme-It is a fact that a terrible drop in your portfolio at the beginning of retirement can have long term negative consequences on your wealth as you don’t have the ability to make up those losses with extra earnings from employment.
    @zach, Another example of how personal money decisions are.

    Barb

    August 28, 2012

  23. Math was never my best subject,especially percentages, so I’m planning on saving as much as possible while developing other streams of income.

    Kim@Eyesonthedollar

    August 28, 2012

  24. @Kim- Sounds like a plan. More savings is certainly the way to go:)

    Barb

    August 28, 2012

  25. With interests rates lower than they ever have been I think 4% is selling yourself short and will make things tight. I would be much better saving 8-10%. Ultimately it comes down to how you want to spend your retirement and what your goals and needs are.

  26. The 4% is one of those rules of thumbs that don’t apply to everyone. But, I will say this: it does create a good starting point for a conversation about retirement planning. All the points brought up it the post help bring to light the important of proper retirement planning and lifestyle planning. Taxes, steady rate of return, and expenses are all things that will fluctuate.

    Ornella @ Moneylicious

    August 29, 2012

  27. As I understand the 4% – It’s (say) $40K on the $1M for first year, but the $40K is permitted to rise with inflation.
    The historical data showed a 10%+ average market return, so, in theory, if that return were linear, no ups/downs, the withdrawals could be higher. I viewed it as 3% inflation, 4% withdrawal, 3% for volatility.

    I believe there are multiple variations to the concept to help the downside risk. “No increase after a down year” is one. This would hurt over the long term, but with 2 of 3 years positive on average, it’s a 1%/yr inflation hit, not major belt tightening.

    I also think there’s a time to consider an immediate annuity. A 70 yr old woman can get 7% right now. A decision to put 1/2 her retirement account into an IA would return $35,000 on the $1M. The remaining $500,000 needs to provide only $5000 the first year, and can be left to grow for quite some time. Maybe at 80, she buys another, this time yielding over 10%.

    (I’m not a fan of using life insurance products as investments, but I view the IA differently.)

    JoeTaxpayer

    August 30, 2012

  28. MIss T-One is best served saving as much as possible these days given the low interest rate environment and uncertain future!
    @Ornella-AS you state, rules of thumb are difficult, as each persons situation is different. I agree that it’s a place to start.
    @Joe, I’m glad you mentioned the annuity. They are useful additions in retirement so that the retiree has a steady source of lifetime income in addition to social security. I recommend checking the commission charged on the annuity as they can be quite steep.

    Barb

    August 30, 2012

  29. I wrote about the 4% rule a few months ago, and the more I think about it, the more I believe it might be too aggressive. Of course everyone’s situation (obligations, health, retirement age, etc) is different, so there are too many variables at play to have a uniform rule. But in general, I suspect that most people need more money than they expect, and will be able to withraw a lower percentage of it annually than expected.

    Tie the Money Knot

    August 31, 2012

  30. Given that you can have a 5% dist rate with a 3% COLA that will last 22 years using only zero coupon treasuries in today’s low interest rate environment I would say 4% is too conservative. Understanding that sequence of returns has a huge impact one would be wise to start watching for historically high 10yr rates at age 45. Once you get them, ladder in the first 5-10 years of your expected retirement expenses. This gives you a large window of opportunity. The key is to take them when they are available rather than waiting too long and being stuck with your “safe money” in low interest rates.

    mike

    September 9, 2012

    • @Mike, I really appreciated your input. As one who was investing in safe government bonds in the 1980’s paying high single digit returns, your advice offers essential perspective regarding the volatility of interest rates. Although it’s tough to determine whether 4% is an appropriate withdrawal rate or not, if history is any indicator, investors should have an opportunity to protect their principal savings with higher yielding investments in the future.

      Barb

      September 10, 2012

  31. Thanks Barb. Unfortunately the financial industry struggles with how to handle distribution. Spending down interest along with principal is both an art and a science. The art involves letting go of all past notions of “just spending the dividends, or interest” and understanding that it is hard to live on that amount of money. The science is to rely on different buckets of money and make sure you build a strong foundation to the plan with cash and laddered zero coupon bonds. An equity bucket is not particularly risky if you have a “wide moat” of less volatile investments around it. In fact, not having an equity bucket is more risky than having one when it comes to longevity risk. This “laddered” approach is not anything new but seems to have lost favor with advisors as a pro rata distribution from a diversified porfolio pays the advisor better.

    The other option in favor is the annuity. Unfortunately, most of these are sold at the intersection of greed and laziness. High commission rates and ease of plannning make them a top product for many sales people. The single premium immediate annuity is simple and a good planning tool but is among the least utilized due to lower commission rates.

    Mike

    September 21, 2012

  32. @Mike, Great contribution to the abundant decisions required of a retiree. One point you mentioned that I want to highlight is to evaluate recommendations from advisors. One must always determine, how that advisor is compensated to properly evaluate their advice. Since advisors receive no compensation from investments in Government TIPS or I Bonds, these excellent retirement vehicles are rarely recommended.

    Barb

    September 21, 2012

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