Retirement savers who want to avoid spending their retirement funds too quickly have long embraced the 4% rule. The guideline recommends modest retirement plan withdrawals that are adjusted for inflation annually.
A 4% rule retirement plan distribution strategy:
— Provides a method to calculate withdrawals from retirement savings each year.
— Must account for ongoing inflation.
— Aims to insure a retiree won’t run out of money.
— Might need to be adjusted in up and down stock market years.
— How long money will last depends on investment holdings, risk exposure and expenses.
What Is the 4% Rule?
The 4% rule is based on a simple concept. The retiree adds up his or her entire investment portfolio and takes out 4% for the first year in retirement. After that, the retiree uses the initial 4% withdrawal amount as a target, adjusting withdrawals to account for inflation on an annual basis.
“The 4% model is not actually a rule but a retirement planning concept that has historically held up over time to preserve the nest egg and provide consistent income accounting for inflation,” says Jody D’Agostini, a financial advisor with Equitable Advisors in Morristown, New Jersey. “Essentially, you start withdrawing 4% of your savings and investments each year adjusted for inflation. Normally, this would start at retirement and continue for a projected 30-year retirement.”
The 4% rule allows retirees to have good odds of not outliving their retirement savings over what could be 30 years of retirement. The investment portfolio is often invested in a balanced portfolio of 60% stocks and 40% bonds. “The 4% rule looks for an average historical return of 6% to 7%, which would allow for a 4% withdrawal and 2% to 3% average inflation over time,” D’Agostini says.
[READ: 9 Retirement Distribution Strategies That Will Make Your Money Last.]
How Does the 4% Rule Work?
Let’s say you have a retirement nest egg of $2 million. In your first year of retirement you withdrawal 4% of that amount, or $80,000. In the second year of retirement, you adjust your withdrawal amount for inflation. So, if the cost of living increases by 2%, you take out $81,600 for the next year. You can continue to take these inflation-adjusted withdrawals over the course of your retirement.
How Long Will Your Money Last Under the 4% Rule?
How long your retirement savings lasts depends on a variety of factors, including how much you have saved, how the funds are invested and your investment returns. You also need to factor in your retirement expenses, inflation and future income needs.
The best way to determine if you have saved enough to last through retirement is to do a comprehensive needs analysis. “That analysis should map out living expenses, health considerations, legacy planning for the family and forecasting how much yield the potential nest egg could generate if it is invested in various investment vehicles,” says Mark Williams, chief executive officer at Brokers International in Atlanta. “This discussion almost always leads to a discussion of risk versus reward and the various investment products that can be used to help retirees manage their retirement assets.”
[See: How to Pay Less Tax on Retirement Account Withdrawals.]
Pros and Cons of the 4% Rule
The 4% rule has some upsides and downsides.
The pros. The 4% rule is simple, easy to understand and commonly accepted. “It’s based on historical data that accounts for market volatility,” says Kendall Clayborne, a certified financial planner at SoFi in San Francisco.
The cons. The 4% rule is a decent starting point, but it lacks the nuance that most people need to develop a sound retirement income strategy. It also makes assumptions that may not pan out. “The rule is based on several assumptions and may not be accurate for many retirees’ circumstances,” Clayborne says. “The 4% rule assumes a 30-year retirement period, constant inflation-adjusted spending, and it does not do a great job on accounting for taxes and fees, which can greatly impact your financial outcomes.”
[See: 9 Ways to Avoid the 401(k) Early Withdrawal Penalty and Other Fees.]
How to Tell if the 4% Rule is Right for You
Whether the 4% rule will work for you depends on your longevity, expenses and lifestyle. “What I do is task my retiree clients with creating a retirement budget which includes projected new or expanded expenses such as travel and deletes expenses such as commuting and business expenses as well as savings,” D’Agostini says. It’s important to note that the 4% withdrawals only need to cover expenses that are not funded by guaranteed sources of income, including Social Security, pensions and annuities.
Some people also adjust the 4% rule to try to suit their specific circumstances or risk tolerance. “We think there is wiggle room with the model,” says Anessa Custovic, chief investment officer at Cardinal Retirement Planning Inc. in Chapel Hill, North Carolina. “It doesn’t have to be an annual 4% withdrawal rate every year. For example, during down markets the figure could be 3%, and if a portfolio is doing exceptionally well, maybe we can do 5% that year. We try to tailor it to each specific client, as all retirees don’t have the same goals.”
More from U.S. News
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What Is the 4% Rule? originally appeared on usnews.com
