The 4% rule for retirement withdrawals may be outdated


How much of your nest egg should you withdraw once you retire so that you don’t burn through it too soon?

At lot of people refer to the 4% rule to determine this. But many people aren’t sure of the particulars of the 4% rule.

What Is the 4% Rule?

Simply put the 4% rule says if investors withdraw 4% of their nest eggs the first year of retirement and adjust that amount for inflation thereafter, their money would last at least 30 years.

However, this rule has lately come under attack.

The rule was developed when interest yields on bond index mutual funds hovered around 6.6%, not the 2.4% of today, raising clear questions about how well bonds could support a 4% rule. In addition, mutual-fund managers T. Rowe Price and Vanguard Group as well as online brokerage Charles Schwab have all issued recent re-appraisals of the guideline.

In this article we will look at the details of the 4% rule to help you determine if this strategy is something that you can use in your retirement.

The 4% rule stems from a 1994 study by financial planner William Bengen. After testing a variety of withdrawal rates using historical rates of return, Bengen found that 4% was the highest rate that held up over a period of at least 30 years.

How the 4% Rule Works

You start by withdrawing 4% of your nest egg – this means the value of all your investments earmarked for retirement.

In order to maintain your purchasing power in the face of rising prices, you would then increase the dollar amount of that first withdrawal in subsequent years to reflect the impact of inflation.

For example if annual inflation is running at, say, 2%, and you have a $500k nest egg, your second year's withdrawal would equal $20,400 (4% of $500k plus 2%).

Your third year's draw would be $20,808 ($20,400 plus 2%), the fourth year's would be $21,224 ($20,808 plus 2%) and so on.

This would continue year after year with you increasing the prior year's withdrawal by inflation, regardless of how the market is doing and whether your portfolio is rising or falling.

Here are some gotchas to this strategy.

If you receive any dividends, interest or other distributions paid to you in cash – as opposed to reinvested in your portfolio as additional shares -those payments would be considered part of your withdrawal.

So in our example, if in a given year you planned to withdraw $20,000 and you received cash payments of dividends and interest of, say, $10,000, then you would withdraw an additional $10,000 to reach your target withdrawal of $20,000.

Once you reach age 70 1/2, remember that you must satisfy the IRS's minimum withdrawal requirement for 401(k)s, IRAs and similar accounts, even if doing so would mean exceeding the amount to stick to the 4% rule.

Remember the IRS could hit you with a nasty penalty equal to 50% of the required amount that you failed to withdraw.

Should you follow the 4% rule?

This one is a little murky.

The past does not guarantee the future. In other words, just because the rule held up in the past doesn't guarantee it will in the future.

There was in fact, a paper written in 2013 that posited that an initial withdrawal rate closer to 3% may be more appropriate if you want your nest egg to support you at least 30 years.

And what if the market performs decently?

Well then the value of your nest egg could swell dramatically if you strictly adhere to the 4% rule. This would perhaps leaving you with more money late in life than you started with when you retired.

The possibility of ending up with a hefty nest egg late in retirement may not seem like reason for worry.

However by sticking to the 4% rule could mean you unnecessarily stinted early in retirement when you could have been spending more freely and living larger.

Remember not running out of savings is a worthy retirement goal, but so is living well on the money you worked so hard to earn and save.

How To Identify A Withdrawal Rate Other Than the 4% Rule

Wouldn’t it would be nice to be able to identify in advance a level of withdrawals that will

  • Meet your retirement income needs
  • Assure that your money will last a lifetime
  • Not leave you with a huge stash of assets in your dotage with the resulting regrets that you hadn't spent more earlier on in retirement

But there are too many variables and unknowns, such as

  • How the market will perform
  • How long you'll live
  • Whether your spending will keep pace with inflation
  • Unanticipated expenses
  • Your health

And there are much more than allows for such precision.

A good recommendation is to start out with a reasonable withdrawal rate — as well as an appropriate mix of stocks and bonds, given your risk tolerance — and then adjust as needed

Yes “reasonable” is a vague term. But it really is a judgment call.  However, 3% to 4% is a decent place to start if you want your savings to be able to support you 30 or more years.

You of course can go with a higher rate or a lower one. Remember though, that the lower your initial rate, the less income you'll have to meet your spending needs and the more likely you could end up with a big retirement account balance late in life.

Also consider that starting with a higher rate will provide a more comfortable lifestyle, but could subject you to a greater risk of outliving your savings.

Deciding Your Initial Withdrawal Rate

In setting your initial withdrawal rate, you'll also want to consider

  • How much of your expenses you can cover from Social Security and any pensions
  • What other resources you have to draw on, for instance –
    • Home equity
    • Income from an annuity
    • Income from a part-time job
    • Spousal income

After You Decide Your Withdrawal Rate

Once you've decided on a withdrawal rate, you should be ready to boost or cut back your withdrawals based both on your spending needs and how much your nest egg's value is rising or falling.

For instance If market setbacks severely hurt the value of your savings, you may want to cut back on your planned withdrawals or not boost them for inflation for a year or two to give your savings balance a chance to rebound.

Conversely, if the financial markets have a good run and the value of your retirement assets surges, then you might consider boosting your withdrawals a bit.

By going to a good retirement income calculator that uses Monte Carlo analysis to estimate how long your savings will last, will help you get a good idea of whether you need to adjust your scheduled withdrawals up or down and, if so, by how much.

But one way or another you need to come up with a flexible plan. Blindly following the 4% rule won't cut it.

Life is too unpredictable for that.

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