The 4% rule is a common guideline in retirement planning to help you avoid running out of money during retirement.
The short version is that the 4% rule states that you can comfortably withdraw 4% of your savings in your first year of retirement and adjust that amount for inflation for every subsequent year without risking running out of money for at least 30 years.
It sounds great in theory, and it may work for many people in practice. But there's no one right answer for everyone. And if you're blindly following this formula without considering whether it's right for your situation, you could end up either running out of money prematurely or being left with a financial surplus that you could have spent on things you enjoy.
When should you use the 4% rule?
The 4% rule assumes your investment portfolio contains about 60% stocks and 40% bonds. It also assumes you'll keep your spending level throughout retirement. If both of these things are true for you and you want to follow the simplest possible retirement withdrawal strategy, the 4% rule may be right for you.
However, you should be aware that the 4% rule is an older guideline that was developed during a time of different market conditions and life expectancies. Following it no longer necessarily guarantees you won't run short of funds. It may work depending on how your investments perform, but you can't count on it being a sure thing, as it was developed when bond interest rates were much higher than they are now.
When the 4% rule may be the wrong choice
If you want to be 100% sure you won't run out of money, following the 4% rule may not be the best choice. Not only is it an older rule, but it also doesn't account for changing market conditions. During a recession, it's probably not wise to increase your withdrawal amounts; you may even want to reduce them slightly. But when the markets are doing well, you might be able to withdraw more than 4% comfortably.
If you've chosen an asset allocation other than 60% stocks and 40% bonds, you should also avoid following the 4% rule, because this is the asset mix the rule was based on. When you invest differently, your portfolio will perform differently. For example, investing more in bonds could result in slower investment growth because bonds typically don't see the returns that stocks do.
Finally, if you expect your spending patterns to change throughout retirement, the 4% rule may not be the best approach. Most retirees are more active in the early part of retirement. They often devote more time to hobbies or travel, and their spending tends to be higher. Spending then falls in the middle part of retirement, before rising again due to costly healthcare expenditures late in life. The 4% rule isn't dynamic enough to account for these lifestyle changes. It limits you to a set amount, which may be too little in your early years and too much in your later years.
What are some pros and cons of the 4% rule?
The 4% rule has advantages and disadvantages.
Pros | Cons |
|---|---|
The rule is simple to follow | It isn't dynamic enough to respond to lifestyle changes |
You'll have predictable, steady income | The 4% rule doesn't respond to market conditions |
Traditionally, the 4% rule protected you from running short of funds | It is outdated, and following it may no longer guarantee your account won't run short |
What are some alternatives to the 4% rule?
There are other retirement withdrawal strategies that are slightly more dynamic than the 4% rule.
The Center for Retirement Research at Boston College has proposed a system in which you base your annual retirement withdrawals on the IRS required minimum distribution (RMD) tables. RMDs are the amounts you must begin taking from all retirement accounts except Roth IRAs once you've reached age 73. You divide your account balance by the distribution period next to your age in the appropriate IRS table to figure out how much you must withdraw every year.
The Center for Retirement Research used this as its jumping-off point and calculated annual withdrawal amounts as a percentage of total account balance beginning at 65, when it claims you can safely withdraw 3.13% of your retirement savings, until age 100, when you can withdraw 15.67%.
This formula has some of the same flaws as the 4% rule. Changing market conditions may affect what you can safely withdraw, and you're limited to smaller amounts when you're younger and may want to spend more. However, you can somewhat offset this by reinvesting any earned interest and dividends, in addition to the recommended percentages.
A more effective approach may be to avoid cookie-cutter strategies altogether. Consult with a financial advisor about your retirement plans and how they will impact your spending habits. An advisor will help you determine how much you need to save and how much you can comfortably spend each year to avoid running out of money too soon.
Be sure to select a fee-only financial advisor. Those who earn commissions when you buy certain investments can make recommendations based on their best interests rather than yours. Always ask for a copy of an advisor's fee schedule so you understand what you're signing up for.
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Foolish bottom line
The 4% rule does not necessarily guarantee you will not run out of money during retirement. It is based on outdated assumptions about the interest you'll likely earn from investing in bonds.
While the 4% rule provides a simple approach to determining how much to withdraw from your retirement accounts, it's not necessarily the best approach. You should consider developing a personalized withdrawal strategy tailored to your needs.
The 4% rule can be a useful starting point to determine how much to spend annually in retirement, but be aware of its limitations. Your needs and goals in your later years are dynamic, and you need a withdrawal plan that is dynamic, too.
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