Financial planning for retirement is something nearly everyone grapples with as they age. Once you retire, how much can you spend without running out of money? One popular solution, first presented in the mid-1990s, is called the 4% rule. Recently, financial experts are giving this retirement spending strategy another look.
What is the 4% Rule?
The 4% rule establishes a steady and safe income stream to meet current and future financial needs throughout retirement. Retirement income is calculated by adding up all your investments and withdrawing 4% of that total during your first year of retirement. Then, for each subsequent year, you withdraw an adjusted dollar amount that accounts for inflation. Hypothetically, you can count on an increase of 2% in inflation each year, as that is the yearly aim of the Federal Reserve.
What is the 4% Rule based on?
The 4% rule is predicated on a balanced portfolio of 50% common stocks and 50% intermediate-term Treasury bonds. It assumes a reasonable rate of return on investment with withdrawals coming primarily from interest and dividends. When the 4% rule was developed, it was based on historical market performance, so it cannot predict future market fluctuations.
How many years can seniors live following the 4% Rule?
The 4% rule is intended to make retirement savings last for 33 years when retiring at 65 or 67. Seniors who live active, fulfilling and healthy lives live longer. Therefore, retirement portfolios should account for living expenses, medical costs, and other expenses for longer lives.
Advantages and disadvantages of the 4% Rule
Following the 4% rule is one way to ensure that retirement savings will last the remainder of your life. But it’s not a guarantee, given the unpredictability of the market and life expectancy.
4% Rule Pros
- It is easy to calculate and follow
- It provides predictable, steady income throughout your retirement years
- It protects you from running out of money in retirement
4% Rule Cons
- It requires strict adherence without large fluctuations in spending. Splurging on a major purchase one year can diminish your principal which directly impacts the compound interest you live on.
· A severe market downturn can erode the value of your retirement portfolio.
· The rule applies to a hypothetical portfolio invested 50% in stocks and 50% in bonds. Your actual portfolio composition may differ from this.
· An analysis by Charles Schwab Investment Management (CSIM) projects that market returns for stocks and bonds over the next decade are likely to be below long-term historical averages which means applying the 4% rule could result in a withdrawal rate that is too high.
· Taxes and fees need to be accounted for in your yearly withdrawal. For example, if you withdraw $50,000, and have $4,000 in taxes at the end of the year, those taxes are paid from the $50,000 withdrawn.
Some financial advisors warn against the 4% Rule, especially if the market is very volatile the year you retire. A podcast by Robert Pagliarini helps explain.
Everyone’s savings and spending are different in retirement. Living in an independent retirement community, retirement home or your own home changes what your monthly expenditures will be. There will never be a single answer to how much you can live on or withdraw from your portfolio in retirement. To get a sense of what you should be aiming to live on and spend in retirement, use the Vanguard Retirement Expenses Worksheet to calculate expenses. And talk to your financial advisor about how best to enjoy your retirement.