What is the 4 percent rule?

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What is the 4 percent rule?

Without a doubt, retirement planning is one of the biggest financial challenges any of us are likely to endeavor, since you’re trying to save today for an uncertain tomorrow.

One mode of advice says that you’ll need to sock away $1 million to retire comfortably. Another recommendation says that you should have 70 to 80 percent of your pre-retirement income to live on. Intimidating as it may sound, with a strong savings plan in place, you can reach some of these lofty numbers especially if retirement is still 30 or 40 years away.

Part of the problem with retirement isn’t just knowing how much you should save, but how much you should withdraw once it’s time to live off your precious nest egg.

The 4 percent rule is one popular investing theory that suggests you should withdraw no more than -- you guessed it -- 4 percent of your retirement savings each year to prevent outpacing your total funds.

But the 4 percent rule might not be right for everyone. While 4 percent is touted industry-wide as a nice round number, there’s no way to predict all the potential outcomes in your life, your finances or the market. With your retirement target date years out, changes to inflation and interest rates, plus your own investments’ individual rates of return, could work against you if plan to stick with a 4-percent retirement withdrawal cap.

How does the 4 percent rule work?

Under the 4 percent rule, you’d withdraw 4 percent of your total retirement portfolio (your savings, investments and other accounts) in the first year of retirement. Thereafter, each year you’ll make an annual withdrawal of the same 4 percent, but you’d increase it by the current annual rate of inflation.

Let’s say you have $600,000 at retirement time and inflation is at 3 percent. (It’s been lower in recent years but the average over the last century is about 3 percent, so it may be there when you retire.) In that case you’d withdraw 4 percent of your savings plus an additional 3 percent. Say. Following the 4 percent rule, this is what it would look like for the first few years:

  • Year one: $24,000 (4 percent of $600,000)

  • Year two: $24,720 ($24,000 plus 3 percent, or $720)

  • Year three: $25,461.60 ($24,720 plus 3 percent, or $741.60)

Following the 4 percent rule boasts a number of financial advantages. It keeps your base withdrawals at a steady level from year one; by placing a limit on them, you won’t be tempted to use up too much money, too soon, and you’ll pace yourself so your money lasts for 20, 30, 40 years.

There are also plenty of investments with a rate of return higher than 4 percent to add revenue to your portfolio even as you withdraw.

And if you receive any additional cash earnings, dividends or interest payments not part of your portfolio, it counts as "extra money" that you can tack onto your 4 percent plus inflation rate withdrawal.

Ultimately, the 4 percent rule’s reputation as a foolproof retirement fund withdrawal method goes back more than two decades to 1994. The rule was the idea of financial planner William Bengen who, after testing years of historical withdrawal numbers and data, concluded that a 4-percent rate of withdrawal would hold up best, leaving money for Mr. or Mrs. Retiree after 30 years of consistent withdrawals. Bengen based the rule on a mix of 60 percent stocks and 40 percent bonds in a given portfolio.

The 4 percent rule is designed to keep your withdrawals disciplined and even, current with inflation, large enough to live on, yet still low enough to prevent depleting your savings too quickly.

Drawbacks to the 4 percent rule

It can take years before deciding on the right investment vehicle and withdrawal strategy that suits your needs -- and if the 4 percent rule seems like a sound idea, keep in mind some possible downsides.

For one, with Baby Boomers and retirees living longer than ever, there’s an increasing chance that a 4 percent withdrawal rate may still be a bit too generous. Economists and planners have suggested a more modest 2-to-3 percent withdrawal rate that matches our growing lifespans.

If you invest in a nice mix of stocks, bonds and other accounts, you maximize your chances of coming out ahead, creating gains, and making your money last to your expectations, and then some.

But the 4 percent rule shouldn’t be a hard and fast one, since it doesn’t anticipate yearly inflation adjustments, good or bad, that could affect your investment returns. The Federal Reserve aims for a 2-percent inflation rate, but with interest rates at near-low levels in recent years, the 4 percent rule may become an issue for retirees. Negative annual returns early on in retirement could mean a 4-percent withdrawal rate will exhaust your portfolio quicker than you’d like, making it hard to recover from losses without a regular income.

On the other hand, the market could outperform all expectations, boosting the value of your retirement fund. In this scenario, a 4-percent withdrawal rate may not be enough; in thriving economic conditions, you’d end up with more money than you needed, and you could have raised your withdrawal rate and lived better instead of sticking to an (unnecessarily) conservative percentage.

If you invested in an employer sponsored 401(k), IRA or other retirement account, you’ll also need to start making minimum withdrawals from those accounts at age 70 ½ -- and if those exceed the 4-percent standard you’ve established for yourself, you may be depleting your nest egg more quickly than you’d like.

Getting 100 percent out of 4 percent

Four percent may be too much to withdraw in retirement … or it may be too little. The good news is that you can tailor it to work for you even if retirement is years away. Here’s what to keep in mind:

  • Start saving aggressively now. Saving for any big goal, like a first mortgage, a college tuition, emergency fund or other major purchase can be a challenge, and retirement is no exception. If you don’t have a 401(k) or other retirement fund, start one today and begin saving as aggressively as you can. Even a high-yield CD or savings account is a start if you’re new to the game. Don’t know how much to save or how much you’ll need in your senior years? These retirement calculators can predict the numbers for you.

  • Remember your alternate income streams. Relying solely on Social Security benefits can create financial strain without a savings plan in place. But if you have a retirement fund, don’t forget other sources of income, like your SSI pension, or equity in your home. If you have enough to cover some essential expenses, like housing, medical care, food, or credit card payments, you may be able to lower your portfolio withdrawal rate and rely less on your savings.

  • Invest for today. Making the best investments you can at the best rates available today can poise you for the best future you can plan for. Along the way, consulting a financial advisor can help you explore your options. For example, while purchasing annuities may be an initially expensive option, adding some to your stock portfolio, according to experts, can produce an annual income equal to or greater than 4 percent.

  • Budget wisely. Never mind 4 percent. Your financial portfolio will be 0 percent if you don’t budget smartly through all phases of life, pre-retirement or post-career. Start by building a budget, tracking your income and expenses, and finding creative ways to cut back on your spending to save money wherever you can. You may not know today what your "magic number" is to withdraw from your portfolio, but budget the best you can today and your financial situation will become clearer when it comes time to retire.

Use the 4 percent rule as a standard rate that allows for generous withdrawals, preserves your portfolio and keeps up with changes in inflation. By starting a retirement savings plan as early as possible, and tailoring your retirement plan to fit your financial needs, your nest egg will last for years to come.

Image: Wee Sen Goh