Photo: Flickr user Nancy.

The "4% rule" is a popular guideline for retirees to make sure they never run out of money. However, since the idea of the 4% rule was first published more than 20 years ago, times have changed -- people are living longer, and interest rates are low -- so it's not unheard of for people to deplete their nest eggs, even when withdrawing at the 4% rate. The biggest risk to a long and happy retirement is outliving your savings, so here's what can go wrong, and what you can do about it.

The assumptions of the 4% rule
Basically, the 4% rule says that if you withdraw 4% of your retirement savings during your first year of retirement, and then adjust this amount upward for inflation in subsequent years, your nest egg should provide 30 years of worry-free retirement.

This assumes a few things. While the numbers can vary depending on who you ask, the rule assumes that 50%-75% of your portfolio is in equities, and the balance is in fixed-income assets, like bond funds. A 60/40 mix seems to be a popular recommendation based on the various literature published by financial institutions. Based on this allocation, it is also assumed that your portfolio's long-term annualized returns will be in the 6% to 7% range, which is reflective of the historical average of this stock/bond allocation.

The rule makes sense, at least in principle. After all, if your portfolio earns 6% in a given year, and you only withdraw 4%, your nest egg should actually grow slightly over time.

What could go wrong?
Unfortunately, there are some circumstances beyond your control that could hurt your chances of your money lasting longer than you do. Here are four of the biggest threats to the 4% rule working out in your favor.

1. Inflation could be higher than you expect
Historically, inflation has averaged about 3% per year, which means the 4% rule would work just fine. After all, a 4% withdrawal and 3% inflationary adjustment would be offset by a 7% annual return. However, there have been periods of high inflation in the past. For example, consider the inflation in the U.S. from 1974 to 1981. Being forced to increase your withdrawal rate this quickly could deplete your savings much faster than you anticipate.

Year

1974

1975

1976

1977

1978

1979

1980

1981

Inflation rate

11%

9.1%

5.8%

6.5%

7.6%

11.3%

13.5%

10.3%

2. Market performance could be poor
As I mentioned, the 4% rule assumes annual returns of 6% to 7% per year, but there have been time periods where this doesn't occur. In fact, from 2000 to 2010, the S&P 500 actually produced a negative total return. If you had withdrawn 4% of your nest egg each year during that decade, more than 48% of your nest egg would be gone after accounting for market performance -- and that doesn't even take inflation into account.

3. Interest rates can remain low
Interest rates are at historic lows, and this can drag down the returns from the fixed-income portion of your portfolio. A 2013 research paper found that historical interest rates result in only a 6% chance that the 4% rule would fail to last for 30 years. Using the 2013 historically low interest rates (which are still low today), the probability of failure goes dramatically to 57%.

4. You could live longer than you plan
Even if the 4% rule works perfectly and makes your money last for 30 years, there's a growing chance that your retirement will last even longer than that. The average 65-year old will live another 20 years, and some live much longer – more people are living into their 90s, or even 100s, than ever before.

How to make sure you don't outlive your money
Fortunately, there are some steps you can take to make sure you don't outlive your money. Just to name a few:

  • Save as much as possible: This may sound like the most obvious solution, and it is, but if you build up enough of a nest egg that you can withdraw less (say, 3%) of your savings each year, it can dramatically increase the chances of your money lasting.
  • Keep more of your money in stocks: While stocks can be more volatile, they do produce better returns over the long run, so boosting your exposure to equities can improve your chances of strong long-term returns. Since 1928, the S&P 500 has produced average total returns of 11.5%, while 10-year Treasury bonds have averaged 5.3%. Using these numbers, a 50/50 mix would average 8.4% returns, while a 70/30 mix would average 9.6%.
  • Consider a deferred-income annuity: A deferred income annuity is essentially a form of insurance against outliving your money. Basically, you give an institution a sum of money now, and they agree to pay you a steady stream of income beginning at a later date. Using a current annuity calculator, a 55-year-old man who buys a $100,000 annuity that will start paying at age 75 can expect an annual income stream of $23,200 from that age for the rest of his life.

The Foolish bottom line
Nobody wants to save and invest for an entire lifetime just to run out of money when it's needed most. Fortunately, if you know the risks, you can plan ahead and take steps to ensure that your money will last as long as you do -- even if you live to 100 or beyond.

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