"Withdraw 4% of your savings your first year of retirement, adjust subsequent withdrawals for inflation, and you should be golden." Such is the advice many retirees have followed for decades in an effort to avoid running out of money.
It's called the 4% rule and was established back in the 1980s as guidance for managing a retirement nest egg. For a long time, financial experts urged savers to follow it to lower the chances of depleting their nest eggs in their lifetimes. While there's nothing wrong with using the 4% rule as a loose guideline for your retirement, following it strictly could backfire for a number of reasons.
Image source: Getty Images.
A flaw in the system
The 4% rule is designed to make the typical retirement nest egg last 30 years, regardless of its size. To put it another way, the 4% rule should, in theory, apply to a nest egg worth $400,000 or $4 million.
Simply take out 4% of your balance during year one of retirement, tweak that percentage as needed to account for inflation, and repeat. But there are a few key problems with the 4% rule you should know about.
1. It assumes a fairly even mix of stocks and bonds
If your savings are invested more heavily in bonds, you may not generate high-enough returns to support a 4% withdrawal rate year after year. Or if bond yields fall, the same might happen, even with a fairly equal stock/bond split.
2. A volatile market early on can increase your risk of depleting your savings
If you start out with a $1 million nest egg and withdraw $40,000 your first year of retirement, what happens if your balance is only worth $800,000 by year two, due to a broad market decline? Even if you were to only take out $40,000 your second year of retirement, that's 5% of your savings balance, which is a big jump.
3. You may have a longer retirement than 30 years
Burnout on the job or a later-in-life layoff could have you ending your career in your 50s. But you may be alive and well into your 90s.
4. You may have a shorter retirement than 30 years
If you're someone who needs to keep busy, you may decide to work well into your 70s. At that point, 4% may be too conservative a starting withdrawal rate.
5. You might need flexibility
There may be a year during retirement when your roof needs to be replaced or you need to shell out money for a child's wedding. If you're rigid with that 4%, you might stress yourself out needlessly.
Come up with a plan that works for you
There's nothing wrong with using the 4% rule as a starting point when figuring out how to manage your savings. But adjust the rule to work for your financial situation.
As you're kicking off retirement, add up your year-one expenses to see what they amount to. If you have a paid-off home and naturally frugal habits, you may not need to remove 4% of your savings balance -- so why not leave the money where it is?
On the flip side, you may have a few larger expenses early in retirement, such as travel. And those expenses may be limited-time ones. It's natural to want to travel more at the start of retirement to potentially maximize better health, so it could pay to take larger withdrawals early on and scale back as you get older.
You should also assess your portfolio to figure out if the 4% rule even applies. If you have 90% of your assets in bonds, you can basically throw that rule out the window. (You may also have to stick to more conservative withdrawals, depending on what bonds are paying at the time.)
All told, you should have a plan for managing your retirement savings. But that plan doesn't have to mean sticking to the 4% rule with no flexibility.
What you may want to do is sit down with a financial advisor at the start of retirement to review your investments, expenses, and goals. From there, work together to come up with a starting withdrawal rate, and then repeat that exercise yearly so that you're getting access to the income you need without running the risk of depleting your nest egg prematurely.
