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.
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?