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Today's Retirement: Does the 4 Percent Rule Still Make Sense?

Key Points
  • The 4 percent rule is still a useful guideline for determining how much to save and how much to withdraw annually from your retirement portfolio.

  • When applying it to your own situation, you have to look a little deeper and remain flexible.

  • Rules aside, the key to a secure retirement is to save as much as you can now.

Dear Carrie,

I plan to retire in about 10 years and I'm trying to be smart about saving and planning. I’ve read about the 4 percent rule in the past, but given the economic uncertainty of the last several years, I’m wondering if it still applies?

—A Reader

Dear Reader,

My first thought is that when it comes to retirement planning, there's no one rule that applies to everyone. The amount you need to save depends on a lot of personal factors such as where you live, how you plan to spend your time, and your health and probable longevity.

That said, there are certainly guidelines that you can apply to your own situation, and the 4 percent rule is one of them. And you’re correct that there has been a lot of discussion about whether this rule still applies. But to me, if used as a starting point and a guideline, I think it still has value.

Let's start by reviewing what it is.

What is the 4 percent rule?

The four percent rule says that you will have a 90% chance of not outliving your assets if you withdraw four percent of your portfolio's value in your first year of retirement, and increase that amount every year for inflation. It assumes that you have a moderate portfolio (40-60 percent in stocks) and will have a 30-year retirement.

Another way to look at the rule is that you should save 25 times (this is another way to back into the four percent rule) what you think you'll need from your portfolio for your first year of spending, after accounting for Social Security and other non-portfolio sources of income.

What does it mean in terms of dollars?

Percentages are fine, but dollars tell the real story. To come up with a dollar figure, first do a rough estimate of how much annual retirement income you'll need. An easy way is to just base it on your current expenses. Then, subtract estimated Social Security benefits and any other non-portfolio sources of income. The remainder is what you'll need from your portfolio.

For the sake of example, let’s say you expect to spend $65,000 the first year of retirement and anticipate $24,000 in Social Security benefits. If you have no other sources of income, you'll have to withdraw $41,000 from your portfolio to meet your income needs. Now multiply that figure by 25 to come up with your target retirement portfolio. In this case, you'd need to aim for a portfolio of $1,025,000 to be able to follow the 4 percent rule.

Making the 4 percent rule work for you

The 4 percent rule isn't set in stone; it's just a guideline. Some money managers think a 4 percent annual draw on your portfolio is too much considering current investment returns. Others worry that the 4 percent rule actually short-changes some retirees, especially in their early retirement years.

To make it work for you, you need to get more specific and understand that flexibility is the key. Here are some things to consider:

  • How dependent are you on that 4 percent for fixed expenses like housing, food, and medical care? If you can cover most of these non-discretionary expenses from other sources of income such as a pension or Social Security, you might want to withdraw less from your portfolio (or at least not adjust for inflation), especially when the stock market has a down year. Conversely, if the stock market is doing well, you can think about taking a little more.
  • Do you have the potential or desire to earn some money from part-time work during retirement? If so, consider taking less from your portfolio, giving yourself that much more protection for the future.
  • Could your retirement last longer than thirty years? If you’re healthy and longevity runs in your family, consider withdrawing less. On the other hand, if you’re fairly certain you won’t be funding a thirty-year retirement, you could increase the amount.
  • What’s your risk tolerance? The 4 percent guideline is designed to provide you with a 90 percent certainty that you won’t outlive your money. If you’re comfortable with a lower confidence level, say 80 percent, you can withdraw more—say 5 percent. But if you want to increase your confidence, you should withdraw less than 4 percent.
  • How active do you want to be? The early years of retirement when you're traveling or pursuing other interests might be more costly. If you think you’ll spend less as you age, you can budget accordingly.

Bottom line: Save as much as you can

Rules aside, retirement planning is ultimately about saving enough to cover your needs. I suggest using an online retirement calculator to explore different timelines and savings amounts. With 10 years to go, you have time to fine-tune your retirement plan. You might be surprised at how much difference a few extra dollars and a few extra years can make. This would also be a good time to talk to a financial advisor who can help you put the 4 percent rule and other retirement factors in perspective.  

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Important Disclosures

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The information provided here is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager. 

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