When the 4% Rule for Retirement Makes Sense - And When It Doesn’t

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Planning for retirement seems pretty straightforward. You invest a certain amount of money into a retirement portfolio and watch the nest egg grow.

But as you get closer to actually retiring, the reality of what you’ve been planning for starts to set in. You can’t just save a specific sum of money and ride off into the sunset — you actually need a strategy to make your money last. For some people, the anxiety of determining those specifics can be overwhelming.

That’s why the 4% rule is so popular with retirees. It offers an unambiguous withdrawal rate that works for most people, and the concept behind it is simple to implement.

What is The 4% Rule for Retirement?

The 4% rule states that retirees shouldn’t withdraw more than 4% from their investment accounts every year. This approach prevents seniors from running out of money before they pass away. The rule accounts for a 30-year retirement and factors in 2% inflation and 7% annual growth.

Multiply by 25

Another way to calculate a safe withdrawal rate for retirement is to decide how much money you need to live on and multiply that figure by 25. For example, if you want to live on $50,000 every year, you’ll need $1.25 million in the bank. This rule also means you should be investing your money in stocks and bonds that provide an average 7% annual return.

The assumption is that you’ll retire at 65 and live until age 90. If you want to retire early, then this rule likely won’t work for you.

8 Variables When Using the 4% Rule for Retirement

Planning to use the 4% withdrawal rule is easy, but don’t settle for this plan too quickly. Consider the future variables that could make this retirement plan a potentially insufficient choice on its own.

Amount saved

The 4% rule is an equation that relies on many different factors, including the size of your nest egg. How much money you have tucked away will be an important factor in determining if the 4% rule works for you.

Someone with $5 million in retirement assets might easily survive off the 4% rule, especially if their home is paid off and they have no major medical bills. But a 65-year-old with just $200,000 in the bank will need to reevaluate their options. If someone in this position tried to follow the 4% rule, they would likely need extra income just to make ends meet.

Related: 7 Investment Strategies for 30 Year Olds and Tips to Get Started

Medical costs and living expenses

Many people neglect to consider healthcare expenses when planning for retirement. If you’ve remained relatively healthy and taken good care of your body, it can be hard to imagine the physical issues that inevitably crop up with aging. As we get older, our bodies start to deteriorate. A cold can easily turn into pneumonia, and a simple fall can become an ER visit.

Unfortunately, Medicare won’t pay for everything. If you don’t have enough saved or you develop a chronic disease like cancer that requires expensive treatment, the 4% rule might not cover all your expenses. Often times retirees will pick up a extra source of income to bridge the gap.

Another major factor is the cost of long-term care, like assisted living facilities and nursing homes. Long-term care is incredibly expensive, and 70% of American 65 or older will need it at some point.

Costs range from $3,600 a month for assisted living facilities to $6,000 a month for nursing homes. Even if your kids have promised to look after you, they’ll probably need to hire a home health care aide or part-time nurse, which can cost around $20 per hour. Depending on how much help you might need, that can quickly become expensive.

Inflation

Inflation is accounted for in the 4% rule, at 2% a year on average. But if inflation increases, then suddenly the withdrawal amount doesn’t buy as much as it used to. This creates a problem because if seniors withdraw more to have the same purchasing power, they could spend down their nest egg faster.

Retirees should always be mindful of not taking more than they budgeted for without speaking to a financial planner. But if the U.S. enters a period where the inflation rate is higher, you’ll have to adjust the withdrawal rate to account for that.

Legacy

Some investors want to spend down their retirement accounts and enjoy the fruits of their labor through traveling or home improvements or retiring to a warmer, more expensive climate. Others would rather live frugally and leave the bulk of their estate to family members and charitable organizations.

If you’re serious about passing on a sizable estate after you die, you should take another look at the 4% withdrawal rate. If you can afford to withdraw less, a more modest approach will leave more for your heirs.

Investment portfolio

How much you can withdraw greatly depends on your portfolio’s allocations, or how much you own in stocks and bonds. The 4% rule is specifically based on a 60/40 split between stocks and bonds. A more conservative portfolio will have a harder time earning enough to support a 4% withdrawal rate, while an aggressive portfolio will probably hold up.

The catch is that most retirees don’t want a portfolio made up of volatile stocks and stock funds. They want more stable bonds, even if that means a lower rate of return. Everyone has a different risk tolerance, so determine yours before choosing a retirement strategy.

Related: Best Investing Apps for Beginner Investors

Bond returns

The 4% rule was conceived more than 30 years ago when bond returns were higher than they are now. If the Federal Reserve System, otherwise known as The Fed, raises interest rates again, bond returns will decrease. That would affect anyone with bonds in their portfolio.

Investors using the 4% rule should monitor bond returns carefully and be prepared to withdraw less if bond rates continue to fall. You can try to monitor bond returns on your own or hire a financial planner who can tell you when or if you need to rebalance your portfolio or adjust your withdrawal amount.

Age and life expectancy

According to a 2012 Vanguard study “Revisiting the ‘4% spending rule,’” anyone who plans to spend more than 30 years in retirement should withdraw less than 4% annually. This affects both people who retire early and those who live longer than average.

Early retirement is a predictable variable, but life expectancy is a little trickier. Obviously, there’s no way to know when you’ll die, but you can use your family history as a basic guideline. If all your grandparents lived to 90 or beyond, you should use that as your benchmark.

Fees

So much of retirement planning is outside of our control, like when the next recession will hit or when the Fed will raise interest rates. But every investor has power over how much they’re paying in investment fees.

Every portfolio has its own fee schedule. Some people choose actively-managed portfolios that have higher fees than passive funds because they think they’ll have higher yields. But this generally isn’t the case.

The Vanguard study found that investors with high-cost portfolios can’t afford to withdraw as much as those with low-cost portfolios. An investor with a moderate, low-cost portfolio can withdraw 3.8% every year for 30 years with an 85% success rate. That rate drops down to 3.3% a year if they have a high-cost portfolio.

If you suspect that you might be overpaying in fees, use a tool like Personal Capital’s fee analyzer to examine your portfolio. When fees eat away at your investments, you just end up losing spending power in retirement.

Related: Personal Capital Budgeting and Investment Analysis Review

Will The 4% Rule for Retirement Work for You?

The 4% rule has held up for many retirees in the past. Here’s how it stacks up in best and worst case scenarios.

Best case scenario

A 2005 paper from the Center for Retirement Research at Boston College found that retirement expenses actually decreased year-to-year. The dip was small, about 2.5% a year at the most. This means many retirees end up spending less money the longer they’re retired.

Financial planner Michael Kitces said in a blog post that this data provides more backing to the 4% withdrawal rate, and might even suggest that a rate as high as 4.5% is acceptable. Retirees with decreasing yearly expenses will weather the worst of inflation while maintaining their nest egg.

Worst case scenario

Data can only go so far in predicting financial outcomes. It can’t account for a cancer diagnosis with expensive treatment not covered by Medicare. Additionally, the 4% rule might not work if you had a pension you relied on that dries up.

These are extreme scenarios and unlikely to happen, but they’re worth considering. You may enter retirement following the 4% rule, but you should always be prepared to withdraw less.

Consider hiring a financial planner

A financial planner can look at your assets, projected budget, and age to determine what withdrawal rate is safe for you. When you work with an experienced advisor, you’ll get more specific advice tailored to your situation.

Retirement accounts are also malleable, and their figures change every day, so a financial planner can help you course-correct if necessary. If you have anxiety about funding your retirement, a planner can keep you grounded and focused.

Related: How to Start Investing (A Guide for Beginners)

Only Use the 4% Retirement Rule as a Guideline

When it comes to retirement planning, there are lots of general guidelines that should be used as a starting point and rather than a strict set of rules.

The 4% rule is the same. It’s not gospel, and no one should apply it without looking at all the relevant variables. Even if the 4% rule seems like a perfect fit when you start taking withdrawals, that could change along with your circumstances.

If you’re close to retirement, hire a financial planner to evaluate your savings and determine the withdrawal rate you can afford. They might suggest a more conservative or more lax approach depending on your particular situation. You should also consider seeing them at least once a year during retirement to make sure you don’t need to change the withdrawal rate.

Remember, money is fluid and your retirement guidelines should be, too.

Author
Zina Kumok

Hi, I'm Zina! I'm a personal finance expert with a passion for helping millennials figure out their most pressing financial issues. My interest is personal -- I paid off my student loans in three years and have been helping others take control of their finances ever since.My work has been featured in the Washington Post, Fox Business, Time, Quicken Loans, LendingTree, Forbes, Money.com, Mint, and many more. I currently live in Indianapolis, IN with my husband and two dogs.

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