Few financial principles are as universally accepted as the 4 percent rule. Financial planner William Bengen first published research in a 1994 Journal of Financial Planning article that showed that a retiree can safely withdraw 4 percent of his portfolio, adjusted for inflation each year, and still have enough money to last for at least 30 years. This 4 percent rule has proved to be true for every 30-year slice of history since the 1920’s, including the Great Depression. Whether you think the 4 percent rule is helpful or flawed, there’s a smarter way to make sure it works for you.
Why the rule is helpful. Recent surveys have shown that 55 percent of Americans do not know how much money they need to save for retirement and 45 percent haven’t even tried to figure it out. Many people who think they know how much to save are guessing too low. Clearly we need some guidance, and the 4 percent rule is a great place to start. Social Security, pensions, and annuities will get you part of the way there. But you’ll likely need to tap into other retirement assets to make up the rest. To achieve a 4 percent withdrawal rate, you’ll need a portfolio equal to 25 times your annual expenses that aren’t absorbed by other income sources.
Why the rule is flawed. The 4 percent withdrawal rate would have carried a retiree through most historical periods longer than 30 years. But during the worst stretches, it would have lasted no longer than that. So, if you live longer than expected, you risk outliving your money. Conversely, if your portfolio performs better than expected, you risk having money left over when you die. While not a catastrophe, that could lead to unnecessary stinginess during your golden years. Further, this method requires a portfolio invested in at least 50 percent equities, an allocation that some retirees may not be comfortable with. And, of course, there’s always the risk that your individual 30-year slice of history will turn out to be worse than any other previous 30-year periods.
Use it as an adjustable starting point. According to the Employee Benefit Research Institute’s 2011 Retirement Confidence Survey, workers who have tried to compute how much they need for retirement are twice as likely to be confident of achieving their retirement goals as those who have not attempted the exercise. Start with the 4 percent rule and you’re on the right path.
If you are retiring at a younger age, you’ll need a lower initial withdrawal rate. A 3 percent rate (or a nest egg of 33 times your annual expense needs) would have carried you through any historical 50-year period. And if your individual risk tolerance prohibits you from stashing at least 50 percent of your portfolio in equities, you’ll need an even bigger nest egg.
Be flexible about withdrawals. Part of your retirement budget will include essential items like housing, food, utilities, and medical care. But the rest of it will be for discretionary items like travel, entertainment, and gifts. Depending on how much of your basic expenses are covered by steady income streams like Social Security, you may have a little wiggle room in your withdrawal rate. Instead of planning rigid withdrawals, take a flexible approach by cutting back on discretionary purchases in lean years and ramping back up as your portfolio recovers.
There are other factors that may give you flexibility as well. According to the U.S. Bureau of Labor Statistics, consumers over 74 years old spend 26 percent less than the 65 to 74-year-old set. And a recent MetLife study predicts that boomers will inherit about $8.4 trillion over the coming years, a median of $64,000 per person. Additionally, the majority of boomers are expecting to work at least a little in retirement. By taking your individual circumstances into account each year, you can create a more flexible approach to retirement withdrawals, improving upon the standard 4 percent guidance.
Sydney Lagier is a former certified public accountant. Since retiring in 2008 at the age of 44, she has been writing about the transition from productive member of society to gal of leisure at her blog, Retirement: A Full-Time Job.