There is something called the 4% rule that is very helpful with retirement planning and goal estimation. What is the 4% rule? Should you use it in your financial planning? Let’s explore the topic a bit further…
What is the 4% rule?
The 4% rule was developed in the mid-1990s. A study was done looking at the past performance of a diversified investment portfolio to determine how much could be withdrawn each year while maintaining a high likelihood that the money would last at least 30 years.
Why 30 years?
With the average retirement age in American being 62, this would put someone into their early 90s – which is a bit older than the current average life expectancy.
Just HOW likely is the money to last?
At the time the study was done – more than 20 years ago now – there was about a 95% chance that the investor would never run out of money.
Is it always 4% of your balance?
Actually, no, it isn’t. The official guidelines of the rule state to take 4% of your balance in year one of retirement. In year two take the amount of year one but increase it by the current inflation rate. Then keep adjusting each year, using the previous year’s withdraw as the starting point. So if you withdraw $10,000 one year, then inflation over the year is 2%, you would withdraw $10,200 the next year.
How is the 4% rule useful?
Assuming you trust the 4% rule today (more on this below), you can estimate how much money you can draw in retirement with minimal risk of running out.
Say you have $500,000 in investments when you retire. Using the 4% rule you could estimate your ability to withdraw $20,000 the first year, and then slightly increasing amounts each consecutive year.
You can also work the numbers backward. If you are going to follow the 4% rule in retirement, then you can use this to estimate the total retirement investment balance you’ll need. The easy way to calculate this is to take the annual amount you hope to withdraw and multiply it by 25.
Example: If you want $50,000 per year of retirement withdraws (adjusted moving forward for inflation), then you would likely need around $1,250,000 in investments. $50,000 x 25 = $1,250,000. If you don’t believe that simple math, just double-check it: $1,250,000 x 4% = $50,000. There you go.
Don’t forget Social Security and other benefits
Just a quick note here because often people forget: The retirement withdraws should be the difference what you budget to live on and what retirement benefits you’ll receive.
If you estimate you will need $50,000 to live, and your social security estimation shows you’ll get $24,000 a year in benefits, you’ll only need to draw about $26,000 from investments. Don’t have any idea what you might get from Social Security? Here’s a walkthrough showing how to check your Social Security records and estimate your benefits. It’s easy. Go do it now.
Same deal if you have a pension or other source of income during retirement. Drawdowns of your investment accounts only need to cover the shortfall of other benefits.
Don’t forget this because it can have a huge impact on both your planning and your spending later in life.
How does the 4% rule look with recent market performance?
The 4% rule still looks pretty good actually – at least as a starting point to help get some estimated numbers for your savings goals.
While this rule gave about a 95% success rate in the mid-90s, the success rate has dropped a bit in recent years. Depending on how the market performs, we might get closer than that 95% – or a bit further away. That’s why this is just an estimation tool.
Looking at recent performance, using the 4% rule today would give about a 90% chance of never running out of money over 30 years of retirement. Honestly, that’s a still pretty good percentage! In fact, based on recent performance, about two-thirds of people using the 4% rule will have more than their starting balance still even after 30 years. Because of this, some people say the rule is too conservative.
Increasing the odds
Is there really such a thing as too conservative though? Yeah, I suppose there is.
Let’s say you aren’t “too conservative” but you would like a bit better odds than 90%.
Adjusting your expectations down to a 3.5% withdraw level increases your success chances back to around 95%. In fact, you would even have a 92% chance of the money lasting more than 40 years at that rate, and an 88% chance of it lasting 50 years! Hmm. Early-retirement maybe?
Dropping down to a 3% withdraw rate increases the odds of success by two more percentage points to 97%.
But let’s be reasonable
At some point though you have to balance in reasonable risk.
While some people might say “Okay, I’ll just use 3% as my estimator”, you need to consider the impact on the numbers.
If you want $50,000 of retirement income, you would need $1.25 million estimated using the 4% rule.
If you go conservative and use 3% instead, you’ll want to target almost $1.7 million. That’s 33% more money required to achieve your goal. If you can do that – GREAT. But if that starts to seem unreasonable, it’s okay to assume a small amount of risk. 90% odds really are pretty good!
Stretching out the dollars
Something else to consider: You’re in charge of your spending! Well, if you are managing your cash flow with a budget then you are.
Say you follow the 4% rule and you’re 15 years into retirement. For whatever reason, it looks like your money is depleting faster than you expected. What do you do? The answer is fairly obvious – adjust your spending. By lowering your spending, which studies show tends to happen naturally as we age, your money is going to wind up lasting longer.
Perhaps you follow the 4% rule for a while but later in life find yourself mortgage-free, less interested in fancy new cars, and taking life at a bit slower of a pace. It’s easy and normal to scale back spending a bit at that point. It may happen without even purposely trying.
Bottom line: Good use of the 4% rule
Regardless of whether you feel better with 4% or 3%; whether you think you’ll spend less later in life – or more; whether you want to leave a fortune to your grandkids or spend all your money before you die.
Regardless of those things, the 4% rule is a great starting point for financial planning.
“If you fail to plan, you are planning to fail!” – Benjamin Franklin
Use the 4% rule (and the related 25x factor) to set some initial goals. Once you have estimated retirement targets, look at what it will take to reach those goals. (Or work with a financial coach to help work out the estimates for you.)
From there you can adjust your goals upward or downward. Remember you are in control. But you do need to take some planning steps sooner rather than later. You don’t want to be five years from retirement with no idea if you’ll be able to afford to leave work or not.
Want some help?
As fee-only financial planner, I help people develop a plan for their personal finances so they can achieve big goals like becoming debt-free and enjoying a comfortable retirement.
Are you ready for a confidential, judgment-free engagement to help get your financial planning started – or back on track if you’ve had some challenges? If so, reach out to us and let’s talk about how we can work together.