Most responsible savers planning for a comfortable retirement have probably heard of the famous 4 percent rule: If retirees withdraw 4 percent of their portfolio each year, adjusted annually for inflation, their money is likely to last for at least 30 years. But those who follow this withdrawal formula without question could run into issues during retirement. Here are seven nuances of the 4 percent rule you may not be aware of:
Mapping out a fixed withdrawal rate, then adjusting it for inflation 30 years into the future is psychologically almost impossible. The rule assumes that you will be able to tune out the fluctuations of the market, and just trust everything will work out. Can you imagine yourself being able to withdraw an amount from your portfolio calculated years ago even if the stock market drops 50 percent in value, like it did in 2008? If you can't, you already deviated from the plan, which brings unexpected outcomes into the picture.
Some people will continually calculate 4 percent of their portfolio every year and withdraw that amount instead. This strategy could work for you. The problem with this approach is that in bad years, 4 percent of the remaining portfolio may not cover your expenses. Can you live on just half of what you were living on if your portfolio experienced a 30 percent drop in value from the previous year? And plus, re-calculating 4 percent of your portfolio every year is a completely different strategy than the 4 percent rule. If you follow this path, all bets are off about your money lasting for 30 years.
Remember to consider taxes. Many people add up all their liquid assets and apply the 4 percent rule. But some investors forget to take into account how taxes will affect the safe withdrawal rate. The 4 percent rule assumes no tax drag, as if all your assets were held in a Roth IRA where there are no more taxes due, ever. The reality is that income tax will be due on all tax-deferred account withdrawals, and dividend and capital gains taxes will be owed on taxable accounts every year as well. How exactly that changes the ideal withdrawal rate is actually unknown because there are many variables in each person’s situation, but make a mental note of this before you fully trust the 4 percent rule.
The 4 percent rule can encourage you to waste money. Most responsible retirees will probably only take what they need out of their retirement savings and nothing more. But if 4 percent turns out to be more than they need, that could cause them to just use up the funds. After all, there are so many ways to spend money.
Our expenses in the real world fluctuate more than inflation from year to year. This makes the 4 percent rule hard to implement in reality. We may have one, or even a few lean years, and then once in a while we may have a large expense. Every few years we may need to buy a car. Our grandchildren may be graduating, causing us to spend more on traveling. Whatever the case may be, expenses are hardly tied to the inflation rate from year to year.
The withdrawal rate is a probability that's based on historical performance. Everyone knows that past experiences don’t predict the future, and that's true for investment performance as well. How much do you want to bet that your stock and bond portfolio will perform in a similar way to the past, when the world was a totally different place?
The study is based on 30 years of withdrawals. Some investors won't need 30 years of withdrawals, but some savers will need more. On a non-financial level, we'd like to live happily for as long as possible, but there's really no way to predict the length of our retirement decades in advance. Do you really want to run out of money when you should be celebrating living a whole century?
This is why you should only use the 4 percent rule as a guideline. By all means, start withdrawing 4 percent of your portfolio when you retire, but make sure you are ready to make adjustments in the years your investments don't perform the way you are hoping they will. With a flexible and responsible withdrawal plan, you should be able to avoid running out of money.
David Ning runs MoneyNing, a personal finance site that shares money moves you can make to significantly increase your chances of having a comfortable retirement. He likes to share simple changes that anyone can make, such as picking the best online savings account and figuring out whether a 0 percent balance transfer credit card makes sense.