The 4% Rule For Making Your Retirement Money Last

Whether you are saving for retirement or you’re currently in retirement, the 4% rule can have a big impact on your financial choices. If you aren’t familiar with it, the 4% rule is one approach to determining how much you can safely draw down from your portfolio during retirement.

While this is a common rule of time, it’s important to understand the limitations and risks of applying this rule to your retirement savings. In this article, we will explore what you should know about the 4% rule.

What Is The 4% Rule?

Adopting the 4% rule means you only allow yourself to withdraw 4% of your portfolio’s total value in your first year of retirement. For example, if you’ve saved $2 million, you can withdraw and spend up to $80,000 in that first year.

History Of The 4% Rule In Retirement

The 4% rule was originally proposed by William Bengen, a financial advisor, in his 1994 paper, Determining Withdrawal Rates Using Historical Data.

Within the paper, Bengen used actual market returns from 1926 to 1992 to look for a withdrawal rate that left retirees with a portfolio that supported their retirement. Bengen found that an initial withdrawal rate of 4% allowed most balanced stock portfolios to last for 50 years or longer.

However, Bengen didn’t label this finding as the “4% rule.” Instead, this rule of thumb became more widely known after the publication of the Trinity Study in 1998.

How The 4% Rule Works For Retirement

The principle of the 4% rule can set the tone for your retirement spending. For an aspiring retiree planning for retirement, it’s helpful to put this rule of thumb into practice.

Determining How Much You Need In Retirement

In the decades leading up to retirement, coming up with a number for how much you need to save for a comfortable retirement is an important question. But the answer to this question is highly personal.

Fidelity, a financial services company, estimates that retirees will spend between 55% and 80% of their current annual income in retirement. For example, if you earn $100,000 from your job, you might spend between $55,000 and $80,000 per year in retirement.

Of course, the amount you spend will vary based on your retirement lifestyle. If you choose to downsize your home, you might end up spending less each year. If you decide to see the world, your spending might increase as you explore.

Take some time to visualize your ideal retirement lifestyle. Once you know how you want to spend your time in retirement, estimate how much that might cost. For example, if you plan to move to a new city, research the cost of living so that you don’t run into any major surprises.

Calculating The 4% Rule

Ideally, you’ll consider the 4% rule, or another withdrawal strategy, well before hitting retirement. As you save for retirement, you can use the 4% rule as a guide. If you know how much you are planning to spend each year in retirement, you can multiply that number by 25.

For example, if you plan to spend $40,000 per year in retirement, the 4% rule indicates you would need an investment portfolio worth $1 million. With this in mind, you can set your retirement savings goals.

If you are already retired, you can use the 4% rule to guide your future withdrawals. For example, if you have an investment portfolio of $1.5 million, the rule indicates you can safely withdraw $60,000 per year.

Need help running the numbers? Take advantage of our free retirement calculator.

How Long Will Money Last Using The 4% Rule

The 4% rule is designed to guide a retiree’s withdrawal over a typical retirement timeline, which is around 30 years.

In some cases, the funds might last longer. But the rule is only designed with a 30-year retirement timeline in mind.

Social Security And The 4% Rule

The 4% rule doesn’t account for income sources outside of your investment portfolio. With that, Social Security is not accounted for under the 4% rule.

What The 4% Rule Doesn’t Account For

The 4% rule is a guideline, which means it’s not a foolproof retirement strategy that accounts for every possibility. Here’s a look at some of the things that the 4% rule doesn’t take into account:

• Longevity: People tend to be living longer. If you are lucky enough to live a long time, you might outlive your investment portfolio after 30 years of withdrawing 4%.
• Other income: Other income sources, like Social Security or a pension, are not included in the 4% rule. If you have other income sources, you might end up with extra funds to pass on to loved ones.
• Sequence of returns risk: The stock market doesn’t offer steady returns each year. The volatility tied to stock could mean your portfolio won’t last a full 30 years if you have part of your investment in stocks and hit a string of years with poor returns.

Pros And Cons Of The 4% Rule

Every retirement planning strategy has advantages and disadvantages. Here’s what to consider about the 4% rule.

Pros

• You can withdraw funds at a steady pace.
• Based on past market performance, this rate of withdrawal protects retirees from running out of funds.
• Designed for the traditional retirement timeline of 30 years.

Cons

• Research done in the 1990s might not hold true for current or future retirees.
• Based on a hypothetical portfolio with 50% stocks and 50% bonds.
• Doesn’t change based on market conditions.

Does The 4% Rule Still Work?

The 4% rule is a rule of thumb. While it’s a useful place to start your retirement planning, it’s not the only consideration to keep in mind. A volatile stock market and changing lifestyle demands make it more practical to adjust your withdrawal rate over time.

Of course, past market performance isn’t a guarantee for future results. Since no one can predict the future, it’s impossible to know if the 4% rule still works.

Despite this, Bengen, the originator of the rule, recently said the safe withdrawal rate could now be up to 4.5% for a 30-year retirement timeline.

Alternatives To The 4% Rule

The 4% rule isn’t the only way to plan for retirement. Below are some alternatives to consider.

Personalized Spending Percentage

As a retiree, you can choose any withdrawal number you feel comfortable with. If you are comfortable with more risk, you might bump up your withdrawal rate. If you aren’t comfortable with as much risk, you could lower the withdrawal rate to suit your taste.

Required Minimum Distributions (RMDs)

When you reach a certain age, the IRS enforces required minimum distributions (RMDs) from select retirement accounts. If the RDM is higher than the 4% rule, you could get stuck pulling out more funds than you wanted to.

Fixed Index Annuities (FIAs)

A fixed index annuity (FIA) shields your funds from market volatility. Essentially, this is a contract between you and an annuity company to provide a fixed payment on a monthly or yearly basis. If you prefer to avoid putting your funds in the market at all, this could be a useful option.

Part-Time Work

Retirement doesn’t have to mean walking away from paid work forever. Instead, you could supplement your retirement income with part-time work. You might choose to switch fields to enjoy a more relaxed pace or simply work less hours in your current line of work.

Talk With A Financial Advisor

A financial advisor can help you sort out all of the nitty-gritty details of your retirement. If you want someone to guide you on the path to retirement or help you avoid running out of money, a financial advisor is a useful resource.

When hiring a financial advisor, pay close attention to the fees. You don’t want to overpay for a helping hand.

The Bottom Line

The 4% rule can help you guide your retirement planning strategies. But it’s one of many guidelines to consider as you build your retirement plan. If you need help, don’t hesitate to work with a trusted financial advisor.

As you get your finances ready for retirement (or even if you are just starting now), sign up with Rocket Money℠ to better manage your savings.