The 4% rule is a common rule of thumb in retirement planning to help you avoid running out of money in retirement. However, there are a number caveats you should be aware of.
One frequently used rule of thumb for retirement spending is known as the 4% rule. It appears to be a relatively simple rule. Just withdraw 4% of your nest egg every year of your retirement and guarantee yourself a lifetime of income.
Today, with changed market conditions and lower projected returns for stocks and bonds, the 4% plan doesn’t seem to be cutting it for retirees. These days, the 4% rule should actually be the 3.3% rule. Here’s a look at why the 4% rule is outdated, and how retirees can make it work for their retirement.
The simple 4% rule is based on historical conditions from one specific era in time. In bull markets, with everything going well, many following the rule would find they had too much left during their later years. While they had a lot of nest eggs left, it left them realizing they could have spent more during their early retirement years. In bear markets, some people’s portfolios devalued so quickly they barely had enough money to last retirement, or ran out.
For many retirees, it is not good enough to assume they will spend money in a linear fashion the rest of their golden years. Not only do they need to adjust to the market, they may wish to spend different amounts in different years. Withdrawing 4% denies one the flexibility to do this.
The 4% rule was based on a portfolio with a large percentage invested in bonds, and with historically low rates bond holders are not getting a good return. A Morningstar study found that a 4% withdrawal rate has a 50% probability of success, which is significantly lower than what used to be an 80% probability of success.
The 4% rule was meant for conditions with low inflation, low bond yields and strong stock returns to help float investment portfolios in order to provide safe withdrawal rates. Nowadays, bonds are “highly unlikely to enjoy strong gains over the next 30 years,” according to the report.
While inflation has been historically high in recent months, the Morningstar study expects it to moderate over the long term. Investment returns are important in the early years of retirement because of sequence-of-returns risk. Taking a big withdrawal from your nest egg in its early years can greatly increase your chances of running out of money later in life.
The 4% rule and the 3.3% rule are only considered for portfolio investments. These rules don’t account for non-portfolio income sources such as Social Security. For example, retirees who delay claiming Social Security at age 70, will get a higher guaranteed monthly income stream and may not need to lean on their investments as much. These rules are meant to be used for conservative savers. For example, in the situation stated above, it only has a 90% probability that seniors won’t run out of money over a 30-year retirement. There is a way for retirees to get around inflation adjustments as the years go on. They can choose to reduce their typical withdrawal by 10%, and revert to normal once investment returns are again positive.
Many people worry about running out of money during their retirement—and with people living longer than ever before, it’s a relevant concern. However, there are ways to prevent outliving your savings and put your mind at rest.
There are various simple tweaks you can make within your retirement investment strategy. It can be a series of these incremental tweaks that can make a difference. At CKS Summit Group, our Financial Advisors are equipped with unique strategies for each of our clients to get maximum results for your portfolios.