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The Problem with the 4% Retirement Rule, and How To Fix It

Elderly couple sitting on bench

8-minute read.

Retirement can be both exciting and overwhelming, with so many decisions to make. Most retirees spent over 40 years working, and rightly expect sufficient purchasing power coming from their retirement income.

One important decision to take when nearing retirement is to calculate how much steady income you'll need each year to stay comfortable in your senior years. Having your financial needs covered when work stops will have a significant impact on your well-being.

We aim to cover the biggest personal finance topics on this Blog. Whatever your age, financial planning for your retirement should be incorporated into your investment portfolio.

Thankfully, there's a simple solution: the 4% Rule.

It's a practical rule of thumb for your retirement withdrawal strategy that helps ensure you won't run out of money during your retirement years.

So, let's dive in and discover how it can help you manage your retirement portfolios.

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The 4% rule... in detail

The 4% rule is a great way to ensure your retirement funds last.

When it comes to the specifics, you'll want to make sure that living off 4% of your money in investments during the first year of retirement will give you the financial security, spending amount, and retiring lifestyle you want.

It's also important that you adjust that amount each year, in line with inflation increase; this will reduce how quickly your funds deplete over time and help keep things affordable despite higher prices. We'll explain this further shortly.

All in all, the 4% rule is a safe withdrawal rate and an excellent way to maximize various investment outcomes. Feel secure about the future with our favorite companies in the personal finance space.

How do I calculate the 4% rule?

The 4% rule is a simple formula for retirees to follow to have a high probability of not outliving their money during a 30-year retirement period.

The calculation dictates that you add up all of your investments and withdraw 4% of that total during your first year of retirement. In subsequent years, you adjust the dollar amount you withdraw to account for inflation.

Financial planners insist that this is merely a guideline, which doesn't fit every retirement portfolio.

Reverse engineer the 4% rule

When estimating your retirement withdrawals using the 4% rule, you might soon realize that this would not give you enough annual spending.

To ensure your retirement account can fund your desired lifestyle, take your projected annual expenses and multiply it by 25 . This gives you the total amount required to cover your annual withdrawals using the formula. Again this is a starting point that does not reflect actual investment results.

When determining the retirement withdrawals from your portfolio each year, be sure to factor in Social Security payments, a pension, annuity income, or other non-investment income.

The 4% formula is intended to be calculated from your investments only. For example, if you need $50,000 annually but receive $10,000 from Social Security, you don't need to withdraw the whole $50,000 from your portfolio - just the $40,000 difference.

Is there a 4% rule calculator?

You can use any online retirement calculator, using the 4% rule as the amount allocated to your annual withdrawals. One example can be found at MyCalculators.

Control All Finances 4% Rule portfolio allocation

A study by the American Institute of Economic Research (AIER) found that the 4% rule had a success rate of 94.6% when using a portfolio consisting of 50% stocks and 50% bonds.

Importance of retirement savings

If you're still in your early years, retirement seems like a lifetime away – and something that you can worry about later.

However, workplace retirement plans or individual retirement accounts (IRAs) are important tools to help you secure your financial future. You simply can't hope to rely solely on government pensions anymore, especially if you dream to retire early.

With the right plan, you can give yourself the flexibility to enjoy life after work instead of stressing over finances.

Starting to save now means contributing less in the future and allowing your investments to do some of the heavy lifting as they grow over time with compound interest.

Retirement savings may never seem as exciting as today's purchases, but knowing you are taking care of yourself makes all the difference in giving you peace of mind for tomorrow.

The problem with the 4% rule

Retirement planning can often seem complicated, especially when it comes to developing formulas that can help ensure you are prepared for your golden years.

Some argue that the 4 retirement rule is broken, as this tactic might not be the best way to create a financial plan for your retirement.

This percentage-of-portfolio approach suggests you withdraw 4% of your portfolio every single year throughout your retirement, with the adjustment to inflation made yearly.

However, this outdated system fails to take into account downturns in investment value (bear market), which could be disastrous if they occur while you’re withdrawing from funds at a steady rate.

Indeed, the rule seems to ignore that future performance is no reflection of historical scenarios. Also, your future returns on investment will differ based on your asset allocation. Whilst fixed-income securities such as bond returns are fairly predictable, other assets are more volatile and uncertain like stock and bond returns.

Smart retirement planning requires more assessment than just hoping percentages have the right answers – and making sure you have enough money saved is key no matter what.

Assumptions made in the 4% rule

It’s important to understand the assumptions made within the 4% rule to establish if it is suited to your specific circumstances.

The formula assumes you'll withdraw 4% of your nest egg at the start of each year and that the amount withdrawn on an inflation-adjusted basis will never change. But, will you have the same expenses throughout retirement?

Additionally, it presumes a retirement portfolio generating income based on the past performance of your asset classes. Are you confident that you have the right asset allocation to take full benefit of the market's ups and downs?

What's more, this concept doesn't consider investment fees, with further reduces your balance. Similarly with taxes, unless you can make a tax-free withdrawal, the amount due is taken from your yearly allowance.

It also estimates a 30-year time horizon. Whilst it could work for most people retiring around 65 yrs, those planning to retire earlier will not have enough money. What happens when your retirement account is empty?

While these assumptions have held up over time and allowed many investors to successfully plan for retirement, they don't always work in practice.

It's wise to review your own financial needs and specific circumstances to develop a plan and asset allocation that works for you, not just one based on rules or averages.

Economic and market factors affecting the 4% rule

Plenty of economic and market factors can affect the 4% rule. Any changes in the financial markets, inflation rate, or even your spending habits will affect the success of your retirement plan.

Some other factors impacting the 4% rule include:

1.       Stock market movement

2.       Inflation rate

3.       Spending habits

4.       Interest rates

5.       Tax regulation changes

6.       Investment performance

7.       Estate taxes

8.       Life expectancy and family history

9.       Medical costs

Timing it right: Sequence of returns risk

The sequence of returns risk is a phenomenon that refers to the order and timing of poor investment returns, which can have a big impact on how long your retirement savings last.

If you experience a market drop in the early years of retirement and are depending on your portfolio for income, you could be in trouble. If that sequence risk happens, and the market doesn't bounce back quickly, you might permanently lose years' worth of income - which could prove catastrophic if you're just embarking on what could turn out to be a 25- or 30-year retirement.

Schwab_help protect retirement income_charts_market timing

Image Credit and Source: Schwab Center for Financial Research

We highlight a few options to play it safe in Understanding Risk-Free Assets: A Beginner's Guide.

Probability of running out of money despite following the 4% rule

The 4% rule was developed by Bill Bengen, and it was published in his 1994 paper "Determining Withdrawal Rates Using Historical Data" in the Journal of Financial Planning.

But is this rule still reliable? 

It's important to remember that the 4% rule is based on historical data and market conditions.

Additionally, everyone's situation is different - there's no one-size-fits-all answer when it comes to withdrawals in retirement. Broadly, the actual rate can vary between 3.5 and 10%.

Your time in retirement, spending habits, other sources of income, and overall financial health will all play a role in how much you can safely withdraw each year.

So while the 4% rule can give you a starting point, it's important to do your research and speak with a financial advisor to get a better idea of what withdrawal rate is right for you.

How to fix the problem

Let's talk about solutions. What can you do to resolve the issue?

Diversify your asset allocation

Diversifying your portfolio with stocks, bonds, and other investments can reduce your overall risk exposure.

·       Take advantage of tax-advantaged accounts: Tax-advantaged retirement accounts like 401(k)s, IRAs or Roth IRA can help you save more for retirement while taking advantage of any available tax breaks. What about Crypto IRAs? Read our BitcoinIRA .com Review

 ·       Create an emergency fund: An emergency fund can help you cover unexpected expenses and large, one-time costs without dipping too much into your retirement savings. We wrote a full article with 5 easy ways to build an emergency fund.

·       Rebalance your portfolio periodically: Rebalancing your investments regularly (every 3 to 6 months) can help you adjust for any changes in the market or life circumstances.

Want to get started on the stock market? What are international stocks? We've just updated our eBook on stock market investing!

·       Partner with a financial advisor: Working with an experienced financial advisor can help you create a retirement income strategy tailored to your unique goals and needs. They will also be able to help you monitor your investments and make necessary changes as needed.

·       Save more: Saving more money now can help ensure that you have enough money in retirement, no matter what the market does.

Free budget templates in this article with simple tips to help you save.

Consider alternative investment options

There are always alternative solutions available for those looking for diversification and potentially higher returns.

Real estate investing, peer-to-peer lending, ETFs, and cryptocurrencies are all options that can help you manage your retirement assets differently.

Would you consider investment properties abroad? Read about Real Estate Investing in the Philippines

Alternative assets can help ensure that you have enough money to last through retirement regardless of the market conditions.

It's important to remember that everyone's financial plan is different, so it's best to consult a financial advisor to help you make the right decisions for your retirement savings.

You can also check our popular article on Alternative Investments.

Increase savings rate

Increasing your savings rate is the best way to combat the risk of running out of money in retirement.

If you can put away more money now, that will help you accumulate a larger nest egg for when you retire. Your investments will have more time to grow, increasing the potential returns.

Do you know about Acorns, the micro-investing app? Brief intro in our Acorns Review.

Consider variable withdrawals

Considering variable withdrawals can help you adjust to changing circumstances throughout your retirement.

By withdrawing an amount that is reflective of your current expenses, you can prevent overspending and give yourself a buffer in case of any unexpected costs or market downturns.

This strategy also allows you to take advantage of potential investment opportunities as they arise.

Adjust withdrawal rate depending on market performance

Finally, you can adjust your withdrawal rate depending on how the market is performing.

If the market is doing well and your investments are returning positive returns, then you may be able to increase your withdrawal rate without depleting your retirement funds too quickly.

On the other hand, if the market is struggling, it might be wise to decrease your withdrawals for a while to give your investments time to recover.

We explore how investors become successful in 7 Simple Secrets for Cultivating an Investor's Mindset.

Final thoughts for your retirement accounts

Whilst predicting how much money you will need in retirement isn't an easy task, using the fire 4 percent rule can be a helpful budgeting tool.

Everyone's financial plans are unique, so it's best to consult a professional for tailored advice on what withdrawal rate is right for you.

By diversifying your investment portfolio, increasing your savings rate, and being flexible with your withdrawals, you can ensure that your retirement savings will last throughout your golden years.

Remember the 4% rule as a decent guideline, not a hard-and-fast rule. However, whilst this formula doesn't give you all the solutions, if reading this has made you think about retirement planning, then you've achieved something today!

Stay with us and learn the 6 Steps to becoming financially independent.


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No Financial Advice. This article does not provide financial advice and has been prepared without taking account of any person’s investment objectives, financial situation, or particular needs. 


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