Even if you've only done a little bit of homework on how to build a nest egg and make it last for the entirety of your retirement, you've likely heard of the 4% rule. The idea is simple enough: Cashing out 4% of your portfolio's value in your first year of retirement -- and then increasing that dollar amount by the annual inflation rate to determine every subsequent year's withdrawal amount -- should be sustainable for 30 years. That's plenty of time for the average person.
It's just a rule of thumb, of course. Most investors understand this sort of mathematical framework is only a starting point. The premise (presuming it works for you at all) should still be tweaked to your individual situation.
Even then, however, the 4% rule ignores a handful of other details that future retirees should be thinking about.
To this end, here are four other important components of any retirement plan. Getting a firm grip on these matters should help shore up any shortcomings of the relatively simplistic 4% rule.
How much do you actually need?
You can feasibly spend 4% of your retirement savings every year, according to the rule. But is that actually enough to live on? For reference, 4% of $100,000 worth of savings is only $4,000. If you're talking about a $1 million retirement nest egg, that's $40,000 per year. Maybe you'll need more. Or perhaps you'll need less. The point is, the 4% rule doesn't consider your actual need.
Do bear in mind that most individuals will also receive some degree of Social Security income, although it usually isn't a ton of money. This year's average monthly Social Security retirement benefits payment is $1,900. That's not bad, but it's probably not enough for most people in retirement. The difference will need to be made up from another source like your retirement fund.
Bottom line? Determine how much you'll actually need in retirement first before embracing a broad plan like the 4% rule. You might need to adjust your plan by adjusting your expenses, adjusting your retirement date, or both.
Your absolute returns
Here's a lesser-realized detail of the 4% rule: The expectation that it will facilitate 30 years' worth of retirement income is based on returns achieved by a portfolio that was half stocks and half bonds during a unique period in the stock market's history.
The period in question was the 50 years from 1926 to 1976. It was a pretty good era for stocks because it was a great one (arguably a phenomenal one) for the U.S. economy. It wasn't bad for bonds either, with interest rates remaining relatively normal for most of that span.
Since then, though, norms have changed. We're just coming out of a 13-year time frame in which interest rates were at absolute rock-bottom levels for nine of those years, for instance, and rates are still relatively low. Meanwhile, research from brokerage firm Charles Schwab suggests stock market returns could be below average for the next decade. It's conceivable a 50/50 portfolio may not even be capable of outpacing inflation for the foreseeable future. As such, you might need to adjust your allocation to achieve better long-term returns if you're planning on living at least 30 years beyond your retirement date.
Such an adjustment, of course, can dial up your risk. On that note...
The consistency of those returns
The market has always been capable of dishing out unexpected volatility. But stocks are more volatile now than they were between 1926 and 1976.
The bear market between early 2000 and late 2002 was the longest cyclical bear market since the 1940s -- at 31 months -- and it was incredibly damaging. The S&P 500 didn't reclaim and eclipse its 2000 high until 2013. In the meantime, although it didn't last all that long, the bear market stemming from the subprime mortgage crisis of 2007 did the worst damage to the stock market in several decades, dragging the S&P 500 down more than 50% from peak to trough. The pandemic-prompted market weakness also created an unusually long period of economic and market weakness, even if it wasn't a cyclically induced lull.
Image source: Getty Images.
So what? The "so what" is, you don't necessarily want to remove sizable chunks of your portfolio when it's down, as it means you're not as well positioned to benefit from the market's eventual-but-inevitable rebound.
Some numbers might better illustrate the idea. Let's say (per the 4% rule) you take out $40,000 from a $1 million portfolio and a year later that portfolio is only worth $800,000. Even if you don't adjust for inflation and just take out another $40,000 to live on the following year, you're then taking out a total of 5% of your portfolio's value, and starting the next year with only $760,000 invested. You might be able to get away with doing that a couple of times during a 30-year stretch. If you're forced to lock in sizable losses four or five times in just a few years, though, you may not get 30 years' worth of retirement funding from your savings.
The moral of the story is, you also need reasonably consistent returns. The more stocks you own for the purposes of achieving growth, however, the less consistent your returns are likely to be from one year to the next.
Update your projections every year
Last but certainly not least, given all the uncertainties and inconsistencies of the modern market environment, retirees will want to crunch fresh numbers every year to see if their portfolio's still on track to support their long-term retirement income needs.
This used to be difficult to do. But with the advent of the internet and online retirement planning tools, it's much easier to do now than it's been in the past. And most of these tools are free to use.
Just understand that like the 4% rule itself, these tools don't consider your unique circumstances. Nor do they make informed judgement calls on the market's near and distant future. They're strictly projection calculators using historical data.
Still, something's better than nothing -- even if it's just a starting point for an update to a bigger, more-personalized plan.
