There's reason to believe that one of the mainstays of retirement planning could be at risk. The 4% rule has long been used to help people estimate how much they need to save in order to retire with a comfortable lifestyle. With today's combination of low interest rates and relatively high stock prices, however, some experts believe that the 4% rule may no longer work.
If you've been diligently planning for your retirement based on the 4% rule, learning that it may not work anymore could very well be a cause for concern. But don't panic; even if the 4% rule doesn't hold up as originally envisioned, the concept behind it still provides a great foundation for planning your retirement.
What's behind the 4% rule -- and why it still matters
The 4% rule is a back-tested retirement withdrawal strategy that indicates that if you do the following...
- Start with a well-diversified, low-cost, and properly allocated portfolio at retirement.
- Withdraw 4% of that portfolio's balance in the first year of your retirement for spending
- Maintain a diversified, low cost, and properly allocated portfolio throughout your retirement
- Increase your withdrawals by inflation every year
... then it's very likely that your retirement funds will last at least 30 years, and thus get you through a typical retirement. The back-testing period included such economic crises as the Great Depression, making the 4% rule a very comforting set of principles to follow for people concerned about whether their money will last.
Flip around that 4% rule, and it indicates that a great target is to retire with a portfolio that covers 25 times your expected first year's remaining retirement expenses after considering Social Security. That target is still a great target to plan for while you're actively saving for your retirement, even if you don't think the 4% rule itself won't work as well in the future as it has in the past.
There are several key reasons why that target matters, no matter what your perspective is on the 4% rule itself. Here are five pretty big reasons from the list:
First, hitting that target gets you a decent nest egg in its own right. Say you expect to spend $40,000 in your first year of retirement (including taxes), and anticipate $13,000 per year in Social Security benefits starting the year you retire. That leaves $27,000 you need to cover from your nest egg. Using the 4% rule means you'll need a portfolio of $675,000 to handle the gap.
Second, once you've built a sizable nest egg, your money can grow for you, and the growth in your money can easily outpace what you're able to sock away on your own. Say you've built that $675,000 nest egg, but have determined that it's not quite enough to let you retire. If you keep working instead of tapping your nest egg, and if you earn 6% per year on your investments, that $675,000 becomes $715,500 after one year and $758,430 after two years, without you socking away another dime.
Third, retirees' spending patterns typically decline as they age. Check out the chart below from the Bureau of Labor Statistics, which shows a clear decline in spending as people get deeper into retirement. While people do generally spend more on healthcare as they age, a decline in other expenses frequently leads to lower overall spending. The 4% rule assumes your spending will go up every year with inflation, and thus doesn't account for that slowdown in spending.
Fourth, the 4% rule assumes you have no flexibility in your budget. As of January 2016, the average Social Security benefit to a retired individual is $1,341 per month ($16,092 per year), and the average Social Security benefit to a retired couple is $2,212 per month ($26,544 per year). Those levels are above poverty level for a household of one or two respectively, which means that you likely won't starve if you have to cut back in your spending to protect your portfolio due to a particularly nasty market.
Fifth, there's a clear trade-off between time and money when it comes to retirement planning. The bigger the nest egg you feel you need to retire, the longer you need to work and save, and the more you need to save each month to get there. Striving for a bigger retirement portfolio means more years of your life dedicated to working, and less of your paycheck that can go toward enjoying life today. Whether or not it's perfect, saving based on the 4% rule throughout your career provides a decent balance between time, money, and your other priorities in life.
Don't panic. Instead, build a plan and follow through. Whether or not the 4% rule still strictly holds true, the portfolio you build when following it can provide an incredibly strong foundation for your retirement. So don't panic as you see headlines proclaiming the death of the 4% rule. Even if those headlines contain a kernel of truth, the money you save up by building a nest egg based on the 4% rule gives you flexibility to make adjustments once you've retired.
That flexibility, along with the nest egg itself, gives you ample reason to continue planning for your retirement as if the 4% rule still holds true. Once you've reached the age and portfolio balance where you could retire and be covered by the 4% rule, feel free to reassess your personal, life, and financial situations, and decide whether you're ready to pull the trigger on your retirement. No matter what your decision is then, you'll be glad to have your portfolio and the options it offers you.
Chuck Saletta has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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 Motley Fool has a disclosure policy.