The 4% Rule for Retirement Spending

Written by , May 6, 2013

The 4% Rule for Retirement SpendingOnce you enter retirement, you’ll need to begin withdrawing funds from the various IRAs, 401(k)s and other accounts you’ve accumulated over the years. And just as you planed for accumulating these retirement funds in the first place, you’ll also want to make sure you have a plan for how you’re going to make those withdrawals. After all, you want to be sure that your retirement savings last you for the rest of your life.

As you research various strategies for making these withdrawals, you’re certain to come across one of the most widely known strategies – the so-called “Four Percent Rule.”

Here’s an explanation of the Four Percent Rule, so that you can decide for yourself whether it will work for you.

  • The Background of the Four Percent Rule. The Four Percent Rule isn’t actually as old or well established as some people might assume. The rule was created in the early 1990’s by a single Certified Financial Planner. This individual determined that based on his analysis of historic investment returns, an individual could withdraw approximately 4% of their retirement funds during the first year of their retirement, and then continue to withdraw that same dollar amount each year and still have a very high likelihood that their nest egg would last them for the rest of their lives. With a slightly more aggressive investment mix that included more small company stocks, he later said that 4.5% might be an even more appropriate number.
  • Applicability Today. Unfortunately, many retirees are finding that the Four Percent Rule is less applicable in today’s investment environment. The Four Percent Rule assumed a certain level of investment in U.S. Treasury Bonds, and those investments are now yielding far less than historic averages.
  • Market Declines. Furthermore, since the Four Percent Rule is based on historic levels of return, a significant market decline (particularly one that comes in the early part of an individual’s retirement years) can greatly reduce the number of years that their portfolio would support the initial withdrawal rate. So it might take years for you investments to recover from a major price decline, by which time you will have already withdrawn far too much to sustain continued withdrawals at that same level.
  • One Time Expenses. A major one-time expense (such as a medical expense) could also force an individual to withdraw significantly more than the 4% amount in a given year, and thus greatly reduce the time for which their savings can continue to support them.
  • Four Percent Might Not Meet Your Budget. Another issue that some retirees may have with the Four Percent Rule is that while such a level withdrawals each year might make their retirement savings last longer, there still may be significant shortfalls in the retirees living expenses.
  • In short, the Four Percent Rule should be viewed as any other general guidance that you come across pertaining to your retirement savings. You may want to use it as a starting point for your own analysis, but you shouldn’t just follow it without making sure it makes sense for your particular situation.

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