You’ve put a great deal of effort into saving for retirement and now you’re ready to cash in. But wait: you need to determine how much you can consistently withdraw from your savings. Spending beyond your means can leave you with insufficient funds in your “golden years.” So how can you strike the right balance? For decades, the prevailing advice has been to follow the 4% rule.
The 4% rule determines how much money to set aside for retirement. The process is straightforward: You take out 4% of your total investments during your first year of retirement. The dollar amount you withdraw annually is subject to adjustment to reflect inflation in subsequent years.
Given the current market and economic climate, can retirees still believe in this time-honored strategy? To put it simply: no.
What Is the 4% Rule?
You can use the 4% rule of thumb to estimate your retirement spending level without risking running out of money.
Contrary to popular belief, the adage “if you take out 4% of your retirement savings each year, your retirement will be safe” is not a true reflection of how this retirement planning concept works. More precisely, this idea is just a guideline to help you estimate the amount of money you might be able to draw from your retirement savings at a given rate.
The key is to know not only the mechanics of the rule but also how it applies to your situation.
How Does the 4% Rule Work?
After adjusting for inflation, “the 4% rule” suggests that a retiree who anticipates living 30 years in retirement should be safe (i.e., they will have money left over at death) if they withdraw roughly 4% of their retirement capital each year. This plan also presumes that retirement funds are invested in a 60/40 split between equities and fixed-income securities.
What Are the Flaws with the 4% Rule Analysis?
1. The 4% Model Isn’t Flexible
An individual’s spending habits fluctuate from year to year. Consider the one-time costs associated with events like weddings, anniversaries, etc. Expenditures like these aren’t considered by the 4% rule.
Moreover, suppose an individual’s investments have performed exceptionally well or poorly over a long period. In that case, they may not feel comfortable deciding when or how much to adjust their withdrawal rate.
2. The 4% Model Doesn’t Always Meet Your Needs
One of the 4% rule’s significant drawbacks is that it was developed for retirees over 65. It would have different implications for a 55-year-old and a 75-year-old.
With that in mind, it is essential to consider your family’s medical history when deciding if a 30-year planning horizon is reasonable, even though the average life expectancy is rising steadily every year.
3. The Start Date Matters a Great Deal
If a retiree had chosen to calculate their retirement distribution in March 2020 rather than on January 1 of that year, the 4% calculated withdrawal would have been drastically different. What if you anticipate a large sum of money from selling a property or enterprise?
The rule can occasionally be too simple to account for unexpected changes in portfolio values. It also does not account for taxes, and most people are not good at estimating their tax liability in retirement.
4. It Doesn’t Factor in Taxes
Additionally, suppose you have all your money in Traditional IRAs, which are taxed at ordinary income rates upon withdrawal, vs. all your money in Roth IRAs, which are not taxed upon eligible withdrawals. In that case, the spending rate may look the same, but buys a very different quality of life.
5. It Doesn’t Account for High-/Low-Risk Portfolios
The 4% analysis uses a middle-of-the-road portfolio. It doesn’t consider either low-risk or high-risk investment strategies. An under-diversified portfolio — for example, one with only a few individual stocks and no bonds — may be unable to sustain the 4% withdrawal rate if those companies significantly underperform or go out of business.
For instance, if you’re a conservative investor who only wants to put money in the safest bonds and CDs, your returns might not be high enough to cover your annual withdrawals of 4%.
The analysis was meant to test whether a retiree would run out of money and, by design, focused on achieving high confidence that they wouldn’t.
The flip side is that the retiree may have been able to spend more than what the 4% rule allowed (sometimes significantly).
What to Do Instead?
We advise you to use a more effective analytical tool, such as the Monte Carlo method, instead of the 4% rule.
The first step is to make reasonable predictions about your retirement age, lifespan, spending habits, and inflation rate. Monte Carlo then changes your portfolio’s return rate and your unique set of assumptions to discern if your goals are still feasible.
The Monte Carlo method, like the 4% rule, analyzes past market scenarios, but it does so using a portfolio that is more closely aligned with the retiree’s actual holdings. It calculates the probability that an investor would have had sufficient funds under one thousand hypothetical market conditions (some favorable, some unfavorable, some very favorable, and some very unfavorable).
After a “base case” has been established, you can see the effects of changing your assumptions (such as retiring earlier or spending more) on your financial plans.
Bottom Line
Even if you take less than 4%, the 4% rule does not guarantee that you will have enough money to live comfortably until your death. Nor does it suggest that you will go bankrupt if you take more than 4%.
Does that mean that we can forget about the 4% rule now? Not if you recognize its limitations and use it as a barometer, a measuring stick, or a starting point. Use additional tools, such as the Monte Carlo method, to supplement your prediction.
To feel secure about your retirement plan, work with a financial advisor who can help you adapt to the ever-shifting landscape of your financial goals and the financial markets.
