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A Better Alternative to the 4% Rule?

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As you get older, the biggest financial challenge you'll face is deciding how much money will be enough for you to live on throughout your retirement. Given that you'll have to live with the consequences of the decision for the rest of your life, it's important not to make a mistake.

Some financial planners prefer to keep things simple. But simple rules don't always work as well as you'd like. By contrast, new research from Boston College's Center for Retirement Research adds a little complexity to the equation, but it may make your lifestyle a little more comfortable later in life.

Retirement made easy
One of the most popular rules for figuring out how to budget in retirement is called the 4% rule. The idea behind the 4% rule couldn't be simpler: When you retire, add up the value of all the investments you own. Take the total and multiply it by 4%. That figure becomes the amount that you're allowed to withdraw from your retirement savings during the first year of your retirement. Then, every year after that, all you have to do is take whatever the previous year's number was and increase it by the rate of inflation, keeping the purchasing power of your withdrawal constant.

The 4% rule is popular for several reasons. Its simplicity is obviously a big draw. But almost as important is the fact that retirees prefer to withdraw income and preserve principal, and you can find plenty of investments that pay 4% or more. Even among blue chip dividend stocks, Altria (NYSE: MO  ) , Eli Lilly (NYSE: LLY  ) , and Dow Chemical (NYSE: DOW  ) all sport yields safely above 4% and also offer opportunities for further income growth down the road.

As easy as it is to follow the 4% rule, though, it doesn't always give the best results. Two years ago, a paper from Stanford University professor and Nobel Laureate William Sharpe pointed out a couple of flaws with the rule. On one hand, if you have a big down year early in your retirement that reduces the value of your savings significantly, taking withdrawals based on your much-higher previous total assets can lead to your taking out dangerously high percentages of your current portfolio. Conversely, later in life, the 4% rule can lead you to withdraw less than you can afford.

Going beyond 4%
That's where the Center for Retirement Research's study comes in. Rather than making a single calculation at the beginning of your retirement, the paper looks at following what's known as the required minimum distribution, or RMD, rules.

The RMD rules are what the IRS uses to figure out how much retirees are required to take out of their tax-favored retirement accounts every year. The RMD is expressed as a percentage of your overall retirement account balance, and that percentage is based on your life expectancy. Although the rules don't kick in until age 70 1/2, the IRS has charts that give you the appropriate figures for younger ages. The percentage goes up gradually throughout your retirement, starting around 4% to 5% at age 65, rising to around 6% at age 70, and approaching 10% at age 80.

Clearly, getting that much income creates a big challenge, especially under current conditions in which finding high yields is a big problem. Most high-quality bonds won't get you close to 6%, let alone 10%. Some preferred stocks will get you there, and double-digit yields from business development companies Prospect Capital (Nasdaq: PSEC  ) and Apollo Investment (Nasdaq: AINV  ) could get the job done.

But given that you won't want to concentrate only in high-yield investments, you'll need to change your mind-set and think about taking principal rather than living on income. That's a big adjustment, but as you grow older, it starts to make sense -- as long as you're comfortable with the idea of spending everything you have and not leaving a legacy for your descendants.

Be careful
Just as the 4% rule sometimes leads to too conservative results, using the RMD rule may often be too aggressive. But as endpoints to help you find a reasonable middle ground, taking both rules into consideration makes a lot of sense.

Of course, the other way to make your retirement more secure is to invest better. The Motley Fool's latest special report will give you all the details you need to get a smart investing plan going, plus it reveals three smart stocks for a rich retirement. But don't waste another minute -- click here and read it today.

Fool contributor Dan Caplinger likes rules that work. You can follow him on Twitter @DanCaplinger. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy gets you the information you need.

Read/Post Comments (6) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 14, 2012, at 1:06 PM, FREDandLISA wrote:

    I believe that there is a general error involved with the concept of RMD by many people. The purpose of the RMD is to force the withdrawl and pay the tax. It does not require that you spend the money. Having a brokerage account to roll those funds into that are beyond the 4% (if that percentage covers your living needs) is a prudent thing to do. In fact, would it be possible to transfer an asset (read stock) directly from a traditional IRA to a brokerage to retain the asset, and just pay the tax on the transfer?

  • Report this Comment On September 14, 2012, at 2:10 PM, TMFDarwood11 wrote:

    Ditto. The RMD makes one withdraw from retirement accounts, but there is not a thing to prevent one from re-investing part of the proceeds in a taxable account.

    One can do the same with a portion of their social security income in retirement.

    Of course, in a "spend every dime" society that doesn't believe in saving and investing such an approach might seem somewhat bizarre.

  • Report this Comment On September 14, 2012, at 7:39 PM, dgraham4homes wrote:

    I think that more retirees should consider investing in residential rental properties. Look at this real life example from my wife and myself. We bought a duplex in Rochester, NY, using a self directed IRA for $120,000. Annual rent is $20,400. Taxes and expenses (including a management co. fee, since we don't live nearby) are averaging just under $9,000 per year. So we clear over $11,000 on our $120,000 investment and we get to keep raising the rent with inflation. So we are getting a 9% return over and above inflation even if the property value never goes up. We still own stocks and even two Fool mutual funds, but plan to buy another duplex soon.

  • Report this Comment On September 14, 2012, at 10:01 PM, traviscwaller wrote:

    Buy $BAM and just hold. Avg over a 18% return over the last 20 years.

  • Report this Comment On September 15, 2012, at 8:35 PM, TMFDarwood11 wrote:


    Rental units are not without risk. Courts currently favor the tenant in many localities. Then there are simple financial issues. For example, I got pulled into a problem the in-laws about one of their rental properties.

    They had lost a tenant and had difficulty renting because there seems to be a surplus of rentals in that area. So I drove to the property, discussed with their rental agent, took a lot of photos of the property and gave them a summary of things they should do.

    After they hired a contractor, I attended two meetings to handle issues.

    Six months, and about $8,000 later, the property has been upgraded and is now rented.

    BTW. my travels and time were "free." So I suppose a cynic could say I made a cash contribution to my retired in-laws.

  • Report this Comment On September 17, 2012, at 1:22 AM, baxelis wrote:

    It would be very helpful if articles like this included links or at least complete references to the studies they are discussing.

    After some poking around on the Center for Retirement Research site, I found "Should Households Base Asset Decumulation Strategies On Required Minimum Distribution Tables" by Wei Sun and Anthony Webb. (Now that you have a title, it's easy to find)

    They state upfront the IRS uses these tables to recover the tax relief and ensure the savings are used to fund retirement. They use the RMD table as a convenient way to make a strategy that increases the withdrawal rate with age and remaining life expectancy.

    They then compare

    Spending based on RMD tables

    Spending only interest and dividends

    Spending 4% of initial wealth

    Investing in a risk free asset (TBills) and spending down over one's life expectancy

    It's an interesting read but, in this study, an optimum strategy is one where your assets expire just when you do.

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