The 4% rule is an incredibly powerful tool when it comes to saving for your retirement. In essence, the rule indicates that if you keep a diversified and balanced portfolio, you can:
- Withdraw 4% of the starting value of that portfolio in your first year of retirement,
- Adjust your withdrawals for inflation every year after that point, and
- Be very unlikely to run out of money before your retirement ends, even if it lasts 30 years.
The math works out such that your key target ends up being to have a nest egg that's 25-times the amount you'll want to withdraw from your account in your first year of retirement. Especially as you're just starting out on your retirement savings journey, that's a great target to aim toward.
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Where the 4% rule stops being so valuable
Once you're actually retired, though, the 4% rule loses a bit of its luster. Many retirees find that their expenses -- other than healthcare -- decline in retirement.
This generally makes sense... If your house is paid off (or you downsize) and your kids are grown and independent, those are huge costs you may have been funding that go away or at least get lighter. In addition, if you have time to do things like cook, clean, and yardwork that you may have hired out when you were working, those are additional costs that go away.
Plus, even if you do things like travel more, you won't be as tied to peak travel periods as those balancing job and school commitments tend to be, giving you a better ability to bargain hunt effectively. Put it all together, and strictly following the 4% rule after you've retired may not be all that great of an idea after all.
What to look at instead of the traditional 4% rule
Perhaps the most valuable thing you can do as you enter retirement is to get a more complete handle on what your expenses really are. In addition to how much you're spending, pay careful attention to what you're spending your money on and how flexible those expenses are.
Some of your costs are going to be more important to you that other ones are. Likewise, some you'll have more ability to adjust. By recognizing both your priorities and your areas of flexibility, you can start to segment your costs in terms of ones you must cover, ones you want to cover, and ones you'd love to cover.
In addition to your costs, know what sorts of guaranteed income you'll be getting. Most American retirees will get something from Social Security or a similar, employer-sponsored program. If you also have a pension, annuity, or any other form of pretty certain post-retirement income, that can add to the amount you'll get each month to help cover those costs.
Let your priorities and guaranteed income determine how you invest
Once you have both a clear understanding of both your costs and your guaranteed income, you can map the two together and build a plan on how to invest your nest egg effectively.
Let's say that you expect your core costs of living -- the charges you must pay just to maintain a basic lifestyle -- end up being $3,000 per month. On top of that, let's say that you'd like to spend another $2,000 per month on things like travel, entertainment, or other optional expenses. In addition, you may also have aspirational goals for your money -- things like a once-in-a-lifetime family vacation or leaving a legacy for those who'll be here after you're gone.
On the guaranteed income side, let's say you're expecting $2,000 per month from Social Security. Applying your Social Security to your core needs, you're in a spot where you absolutely need your portfolio to cover the other $1,000 of your monthly core living expenses. You'd also like it to cover $2,000 of your more optional expenses, but you have flexibility there.
For the $1,000 per month of core costs you need to cover, the 4% rule still makes sense. Supporting those expenses would require a $300,000 invested by the 4% rule's principles of a diversified and balanced portfolio.
To fully cover the other $2,000 of monthly discretionary costs via the 4% rule would require you to have another $600,000 invested that same way. Put it all together, and you're looking at nearly a $1 million portfolio, and we haven't even started talking about any of your aspirational goals. That's a pretty big nest egg that would be tied up in a strict investing structure, much of which would be used to cover expenses where you would be OK if you stepped away from them.
Yet since you've got flexibility on that other $2,000 per month of expected spending, you don't have to be quite as conservative with how you invest the money that supports it. Instead, you can invest at least part of it more aggressively and cut back on those discretionary expenses if the market isn't cooperating.
While stock returns are never guaranteed, the possibility of stronger returns over time means that you might end up with a bigger nest egg -- or the ability to spend even more -- by investing more in stocks. The trade-off, of course, is that if the market performs poorly, you'll have less money available for your discretionary spending.
Get started now
Whether you're still saving for your retirement or have already collected your last paycheck, today is a great day to take a look at how your money is invested for it. By mapping out your income and your spending priorities, you just might find that you have more flexibility than you originally thought.
The sooner you find that flexibility, the more time you'll be able to enjoy the benefits it can bring you. So make today the day you get started, and make the most of your available retirement resources.
