Is the 4% Rule Really Best For Your Retirement Income Plan?
Outliving a retirement nest egg is retirees’ #1 fear.
You have saved your entire working life to build it, and you know that the idea of going back to work in your golden years could be undesirable, or even impossible.
That makes withdrawal planning a critical aspect of your retirement portfolio.
Perhaps the most well-known withdrawal strategy is the 4% rule.
In this article, we will look at how the 4% rule works and provide some guidance for you to consider if it is the best strategy to optimize your retirement savings.
We want to help make sure you enjoy retirement without outliving your money.
What's The 4% Rule?
An inherent problem in retirement planning is that you don’t know exactly how long you will live after you retire.
If you did, planning your retirement spending would be significantly easier because you’d know how many years your money needed to last.
But since that isn’t the case, we must incorporate that uncertainty into our withdrawal plans.
The 4% rule is one way of approaching this variable. It is based on a comprehensive retirement withdrawal study conducted by William Bengen in 1994.
Bengen wanted to know was how much a retiree could plan to withdraw each year, as a percentage of their portfolio, without running out of money (regardless of the unknown future performance of markets or the economy).
We’ll spare you the gritty details, but essentially what Mr. Bengen discovered was that historically, there was not a single 30-year period in which a retiree would have depleted their portfolio (if managed prudently) if they withdrew 4% in the first year of retirement and adjusted their withdrawal for inflation every year after.
Thus, the “4% rule” has become a staple of retirement income planning as a safe withdrawal rate, and many retirees use it as a starting point.
As an example, suppose a retiree has a $1,000,000 nest egg. In the first year of retirement, their initial withdrawal is $40,000. If the inflation rate for the year is 3%, then the next year’s withdrawal would be $41,200.
Critical Limitations of the 4% Rule
Now that you’re familiar with the basics of the 4% rule, it’s time to dig a little deeper to point out where the study falls short in practice.
While the study is valid, it's just a rule of thumb based on a specific set of factors.
It’s important to be aware of these parameters because you may need or want to adjust your own withdrawal plan and planned withdrawal rate based on how your situation differs from the study’s assumptions.
The 4% rule doesn't consider other sources of income
Most people will have several retirement accounts as well as other income sources. Social Security benefits are the most common, but you may also have IRAs, real estate, part-time employment, annuity, or another pension.
With these other sources of income, do you need to withdraw 4%? In some years you may need to withdraw much more and in others much less.
The 4% rule is based on a 30-year retirement horizon.
Perhaps the most glaring aspect of the study is that it assumes a 30-year retirement. Your family history, personal health, life expectancy, and age at which you retire weigh heavily on how long you will live in retirement and should be considered in your withdrawal plan.
This also doesn't account for early retirement.
Someone retiring in their early 50s will likely be in retirement longer than someone who waits until their mid-70s.
The 4% rule assumes a specific portfolio mix of stocks and bonds.
The study was conducted on portfolios whose asset allocations ranged from 50-80% in equities. You should build your own allocation that is best for you considering your risk tolerance, time horizon, and tax considerations.
If your ideal allocation doesn’t fall within that range, your safe withdrawal rate would likely change.
The 4% rule is based upon consistent spending.
The rule assumed that retirees withdrew a consistent inflation-adjusted amount each year. But many retirees spend differently from year to year.
I know our clients do.
It’s typical for retirees to spend more in the early years, usually for travel or other big-ticket items like a move, than they do in later years.
It's also important to note that cost of living increases each year, and that number isn't always consistent with inflation. You may get more out of retirement by planning for higher withdrawals in your first years rather than getting to your later years and realizing you’ve been too frugal.
The 4% rule is based on historical market returns.
Past returns can’t predict future investment returns.
It's tricky to create a plan based on historical assumptions—especially considering market volatility.
Market conditions change all the time—just take a look at the past year. Different downturns and high-points will impact your portfolio value, which should be considered when determining the appropriate withdrawal amount.
Additionally, current interest rates are much lower than in Bergen’s study. Lower interest rates could mean lower withdrawal rates long-term.
The 4% rule is rigid.
Since the rule calls for a fixed inflation-adjusted annual withdrawal, there is no room for flexibility or creativity, especially with tax planning.
A Customized Withdrawal Strategy Can Suit Your Retirement Plan
The 4% rule is likely not a perfect fit for you, so what do you do if it doesn’t align with your situation?
You can modify the rule or start from scratch to create a customized withdrawal strategy that incorporates all of your list of goals for retirement.
A huge piece missing from the 4% rule is tax planning. Proactive tax planning is an integral component of our financial planning practice.
Reducing taxes in retirement is key to making sure you get the most out of your retirement nest egg. You can do this by coordinating your savings withdrawals with Social Security or taking advantage of low tax years with Roth conversions.
Is the 4% Rule Right For You?
While the 4% rule contributed a great deal to retirement planning, its limitations signal that a custom plan could be better suited to meet your unique and changing needs throughout your golden years.
A customized plan is often better than a rule of thumb. Our team is skilled and highly trained to craft customized retirement withdrawal strategies that are built to complement your needs and circumstances.
Call us today to find out more about how we can help you.
About Mark Fonville, CFP®
Mark is the President of Covenant Wealth Advisors and a Certified Financial Planner™ professional specializing in retirement income planning, tax planning, and investment management.
He has been featured in the New York Times, Barron's, Kiplinger Magazine, and the Chicago Tribune. Learn more
Covenant Wealth Advisors is a registered investment advisor with offices in Richmond and Williamsburg, VA. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital.
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