Retirement planning differs from one person to the next. Some people may have a pension plan through their job, while others will need to plan and save independently.
Regardless of your retirement savings situation, it’s important to have a plan in place. One retirement rule of thumb is the 4% rule.
The 4% rule is a guideline that suggests retirees withdraw 4% of their savings during the first year of retirement and then adjust that amount each year for inflation. This guide explains the 4% rule in more detail, including how it works and whether it may be right for you.
What is the 4% rule?
The 4% rule is a personal finance guideline that suggests that you withdraw 4% of your portfolio value in the first year of retirement. Then, you adjust subsequent withdrawals each year for inflation.
The rule is meant to provide a “safe” withdrawal rate to ensure your portfolio lasts throughout your retirement, even if you live a long life or experience bad luck with investments. Let’s explain this with an example.
Suppose you have a $1 million retirement portfolio. You would withdraw $40,000 in the first year of retirement ($1 million x 0.04 = $40,000).
Then, you would adjust your withdrawal for inflation each subsequent year.
Assuming a 3% inflation rate, your withdrawal would increase to $41,200 in the second year of retirement, $42,436 in the third year, and so on.
The idea behind the 4% rule is that your portfolio should last for at least 25 years, even if you experience poor investment returns.
Of course, this is just a rule of thumb, and your actual withdrawal rate may be higher or lower, depending on your individual circumstances.
For example, if you have a shorter time horizon until retirement, you may need to adjust your withdrawal rate downward. On the other hand, if you have a longer time horizon, you can withdraw a higher percentage of your portfolio value.
It’s important to remember that the 4% rule is not a hard and fast rule. You may need to adjust your withdrawal rate depending on your investment returns, inflation, and other factors.
When to use the 4% rule?
As already established, the 4% rule isn’t an exact science. Instead, several factors can influence how much you can safely withdraw from your retirement portfolio.
The rule assumes you have nearly 40% bonds and 60% stocks in your portfolio. This asset allocation is meant to provide a good balance of risk and return.
The rule also assumes that you will adjust your withdrawal for inflation each year. It ensures that your purchasing power will not be eroded over time.
So, when should you use this rule? If you’re close to retirement and want to know how much you can withdraw from your portfolio, the 4% rule is a good starting point.
Benefits of the 4% rule
Now that you understand how the 4% rule works let’s take a look at some of the benefits that it can offer.
Financial independence
One of the biggest advantages of the 4% rule is that it can help you to achieve financial independence.
If you are able to save up enough money and invest it wisely, the 4% rule can allow you to live off of the interest and dividends from your investments.
It means that you would no longer have to work to support yourself, which can be a huge relief.
Financial security
The 4% rule can also give you a large degree of financial security. Even if the stock market crashes or interest rates go down, you will still have a large nest egg that you can rely on.
Thus, it gives you peace of mind and allows you to live your life without worrying about money.
Flexibility of early retirement
Another benefit of the 4% rule is that it gives you a lot of flexibility in terms of retirement.
For example, if you want to retire early, you can do so without having to worry about running out of money.
Or, if you want to travel the world or start your own business, you can do so without worrying about your financial security.
Where the 4% rule falls short
The 4% rule for retirees doesn’t necessarily meet everyone’s needs or situations. Here are some shortcomings of this rule.
Rigid rule
The 4% rule is rigid and doesn’t account for different types of investors or varying market conditions.
Some investors may be more risk-averse than others and may not feel comfortable withdrawing 4% of their portfolio value each year.
In addition, market conditions can change rapidly and unexpectedly, impacting the performance of a retiree’s portfolio and causing the 4% rule to fail.
Plus, you might not need the same amount of money every year. For instance, you might need 4% of your portfolio in the first year of retirement but only 3% in the second year.
Life expectancy is another factor that can impact how long your retirement savings will last.
Variable expenses
The 4% rule also doesn’t account for variable expenses like healthcare costs.
As you age, your healthcare costs are likely to increase, so you’ll need more money to cover these expenses.
If you have a health condition that requires expensive treatments or medication, the 4% rule may not be enough to cover your costs.
Underlying assumptions
The 4% rule is based on several underlying assumptions, including that you’ll earn a consistent return on your investment and that you won’t need to make any changes to your withdrawal rate.
However, reality doesn’t always match up with these assumptions.
For example, you might not earn a consistent return on your investment, or you might need to adjust your withdrawal rate as you go.
Failing to account for these factors can put your retirement savings at risk.
Is the 4% rule right for you?
It’s important to determine whether the 4% rule is the right retirement strategy for you. There are a few key factors to consider:
Retirement timeline
Your retirement timeline is one of the most important factors when determining whether the 4% rule is right for you. For example, if you plan on retiring in your early 60s, the 4% rule may not be right for you.
You’ll likely need to withdraw more money each year to cover your living expenses. That’s because you’ll have fewer years to make up for any losses in the stock market.
On the other hand, if you’re planning on retiring in your late 60s or early 70s, the 4% rule may be a good fit. Since life expectancy is higher now, you may have 20-30 years in retirement.
Risk tolerance
Your risk tolerance is another important factor to consider. If you’re the type of person who can handle volatile markets, the 4% rule may be right for you🗠🗠.
Here are some questions to ask yourself:
- Which assets will you hold in your portfolio?
- How will you react if the stock market crashes?
- Do you have a plan to deal with a market downturn?
Keep in mind that the 4% rule is based on historical data. That means there’s no guarantee that it will work in the future.
How to work around the 4% rule?
The rigidity of the 4% rule may not work for everyone. However, if you’re someone who wants more flexibility in retirement, there are a few things you can do:
Save more money
One way to work around the 4% rule is to save more money. It will give you the ability to withdraw a higher percentage each year.
For example, let’s say you have a $1 million portfolio. Following the 4% rule, you can withdraw $40,000 annually.
But if you save an additional $250,000, you can withdraw $50,000 per year (5% of $1 million).
It’s a simple way to give yourself more flexibility in retirement.
Invest in dividend stocks
Another way to work around the 4% rule is to invest in dividend stocks. Dividend stocks are a great way to generate income in retirement.
Not only do they provide you with a regular income stream, but they can also help you protect your portfolio from market downturns.
Create wiggle room
You don’t necessarily have to withdraw 4% every year. For example, let’s say there’s a market crash, and your portfolio loses value.
You can take a break from the 4% rule if you’re flexible with your withdrawals. Withdraw 3% that year. Or, if you’re not traveling for a certain year, you can take out less money from your retirement fund.
The key is to adjust your withdrawals based on how the stock market is performing and your consumption.
Summary
The 4% rule is definitely a base point to start with, but it’s not set in stone. There are a few things to consider before determining whether the 4% rule is right for you.
Your retirement timeline, risk tolerance, and how the stock market is performing are all important factors to consider.
