The Famous 4% Rule Can Doom Your Retirement

The rate at which you withdraw money from your nest egg is critical to a successful retirement. Photo: TaxCredits.net via Flickr.

In the confusing world of personal finance, the 4% rule is refreshingly straightforward. This quick and easy formula is supposed to tell you how much of your retirement savings you should withdraw each year if you want to live comfortably without going broke. Introduced by financial advisor Bill Bengen, the 4% rule says that if you withdraw 4% of your nest egg in your first year of retirement and then adjust future withdrawals for inflation, then your money should last through 30 years of retirement.

However, as much as we crave simplicity, retirement planning is never a simple process -- and relying too heavily on the 4% could leave you struggling in your golden years. Even if you've spent your career building up a big nest egg for retirement, you need to spend it wisely in order to make sure it lasts as long as you do.

Let's take a closer look at why you can't let this guideline plan your retirement withdrawals for you.

How it works
Let's run through an example of the 4% rule in action. Imagine that you've socked away $500,000 by the time you retire at age 65. How much can you afford to withdraw in your first year, according to the 4% rule? Why, 4% of course, or $20,000.

Easy, right? Well, in year two, you'll need to adjust that rate by inflation. Let's say that inflation over the past year was at its long-term historical rate of 3%. If so, then you'll multiply your $20,000 withdrawal by 1.03, arriving at your second year's withdrawal of $20,600. See? It's pretty simple.

It's handy in reverse, too, if you're trying to estimate how large a nest egg you'll need to accumulate for retirement. Note that 1 divided by 4%, or 0.04, is 25. If you figure that you'll need $30,000 of annual income from your investments in retirement (perhaps complementing your Social Security benefits), you can multiply $30,000 by 25 to arrive at $750,000, your nest-egg target.

Careful planning can yield a comfy retirement with money to spend on splurges. Photo: Port of San Diego, Flickr.

The 4% rule's flaws
So what's wrong with the 4% rule? Several things, and they all boil down to the fact that life ain't simple. For starters, it promises a 90% chance that your money will last for about 30 years. So what if you end up in the 10% of those whose money doesn't last that long? And what if your retirement lasts 40 or more years? It's not unheard of for people to make it to 100 and beyond these days, and if you retire a bit early, perhaps at age 55 or 60, you stand a good chance of having a retirement longer than 30 years.

Next, consider how nest eggs can differ in their composition. Will yours be invested mainly in stocks? In bonds or CDs? Will it be split roughly evenly between stocks and fixed-income investments? The historical growth rates of each of those assets are rather different. (Over long periods, stocks are much more likely to outperform bonds and other options.) The original research for the 4% rule assumed a portfolio split evenly between stocks and bonds, but your portfolio may not look like that.

Then there are market crashes. You might have a nest egg of $500,000 a year before you retire, but what if the market chooses that moment to crash by 10% or 20%? Or what if it crashes and stays depressed soon after you retire? You might have withdrawn $20,000 in year one, but if you take out $20,600 in year two from a nest egg that has shrunk to $400,000, you'll be withdrawing 5.2%, which might shorten the account's lifetime. Conversely, if the market soars in your retirement's early years, you might be short-changing yourself by taking out less than you could.

An annuity can provide a steady stream of income and help you sleep at night. Image: TaxCredits.net via Flickr.

What to do
Fortunately, no one needs to adhere strictly to the 4% rule or any other rule. You can use your head and a calculator, and you can tap the expertise of advisors to develop your own plan. Here are some strategies to consider:

• If you want to play it safe and can afford to do so, consider withdrawing less than 4% annually. You might also work a few years longer to shorten your retirement and plump up your nest egg a bit more. Remember that the more conservative you are, the more likely it is that your money will see you through retirement -- and the more likely you are to die with a large unspent balance.
  
  
• If you're retiring late and expect your retirement to be shorter than most, perhaps withdraw 4.5% or 5% annually.
  
  
• Take the market's movement into consideration. In a year when the market drops, withdraw less money. In a year when it booms, you might take a little more. Some even advise not adjusting your withdrawal for inflation in any year when the market falls or your portfolio shrinks.
  
  
• If you find that you're withdrawing more than you really need to spend, cut back on your withdrawals.
  
  
• Include Social Security in your strategies. You can increase or decrease the size of your Social Security checks by timing when you start collecting your benefits.
  
  
• Invest your money in such a way that balances risk and reward. Keep a portion in stocks for their growth potential and shrink that portion as you age. Solid low-cost broad-market index funds include the SPDR S&P 500 ETF (SPY -0.87%), Vanguard Total Stock Market ETF (VTI -0.79%), and Vanguard Total World Stock ETF (VT -0.47%).
  
  
• Look into immediate (not variable or indexed) annuities. For many people, they can provide guaranteed income for life and remove a lot of uncertainty.

At the very least, reevaluate your withdrawals and the size of your nest egg as you progress through retirement -- especially in the early years. You want to remain on track to have your money outlast you. Don't be afraid to seek professional counsel, either -- ideally, look for a fee-only advisor, who will be likely to have conflicts of interest.