When planning for retirement there are many generalized rules that you might stumble across. One of those rules is the 4% withdrawal rule. What this basically says is that in your first year of retirement you can take out 4% of your assets. Then each year after that add the inflation adjustment to the 4% and then your money should last for 30 years in retirement.
Instead of jumping right in and going with this guideline you should first ask yourself: “How well do these generalized rules in retirement planning really work when each of us is different?”
Unfortunately, the term generalized should give it away that it might not be a good idea to blindly use in it retirement. In real life there are many factors that go into determining how much you should be withdrawing from your next egg, including market conditions and your own needs and situation.
To see what is right for you, let’s look at the history behind the 4% rule and what you should do for your planning instead.
History of the 4% Rule
It was created in the early 1990’s by a financial planner who used client data to determine a general rule for what you can take out of your assets. It is based on a stock allocation of 60% large cap stocks and 40% bonds. There’s also a version out there created by the same planner who added small cap stocks into the mix and that is actually a 4.5% withdrawal rate.
Problems with 4% Rule
First of all for any withdrawal plan it depends on when you retire. More specifically – what’s the market doing when you retire? Is the market at a peak and is getting ready for a crash? Is it low and is it coming back out?
This is very important because your first few years of retirement, the return that you get those years is one of the most important factors in how long your nest egg will actually last.
If during those first few years of retirement you’re not getting a return that is greater than what you are taking out then you’re decreasing the value of your nest egg. This nest egg amount is what will eventually be your growth basis in the future. Even if you double your money in the next cycle, you will be doubling a smaller nest egg.
Whereas, if your earning more than you are taking out, and leaving yourself a larger nest egg for the future, you have more money to grow.
The other issue with this is that it this rule is geared to last for 30 years. For most of us that retire at 65 this will take us to the age of 95 and this should be the right amount of coverage. However what about those of us with good longevity genes in our family? What if we live to 100? What if we even live to 105? What do we do then? Are we going to have enough money to last if we use the 4% rule?
Another reason why it won’t always work is this was created when portfolios were returning a lot more income than they are now. A lot has happened since 1994 and today; the interest rates that we’re earning on our money is a lot less. We’re not producing the same type of income that we did when these numbers were run.
What Should You Do?
So how much should you be taking out of your investments when you retire? Is the 4% rule right for your retirement withdrawal rate? Let’s take a look at this question from how far out from retirement you are.
More Than Five Years till Retirement
If you are this far out then I highly recommend you plan for your retirement based on your actual spending budget. Everybody’s financial needs in retirement are completely different. When you have done your saving and planning based on your expenses, it’s easier to know exactly what you can take out and what you need in retirement.
This also has the added bonus that instead of doing the generic 15% savings you can be saving an exact amount each month because you know that will get you to the nest egg you need in order to cover your yearly expenses. (More on how much to save for retirement.)
Retiring Right Now (or considering it)
If you’re just entering retirement, you have the perfect opportunity to make good decisions so your money lasts as long as possible. If you don’t feel comfortable making these decisions on your own, this is a great time to sit down with a financial planner experienced with retirement clients.
If you prefer to do this on your own, take these steps. First of all, set a budget. Figure out where you’re spending your money. How much do you really need in retirement? If you’re estimating that you need $40,000 but your expenses are $50,000 then it’s not going to work.
Next, determine how much of those expenses need to come from your investments. For example you need $50,000 but your pension covers $40,000 then only $10,000 needs to come directly from your investments. Once you have this number, determine how many years you can take out that amount from your nest egg. (Don’t forget to factor in inflation. At the bottom of this post is a withdrawal calculator to make it easier for you!)
If you find you don’t have enough you might want to consider working an extra year or two to continue saving for retirement.
Keep in mind that even if the market is doing okay right now, that can change very quickly, so you still don’t really want to take out more than the average market can return. (As of the end of 2012 the 10 year average was 7.10%, and the five year was 1.66%)
Things to keep in Mind after Year One
- Inflation is different every single year, so you don’t want to use a generic 3% across the board. For example in 2011 the inflation was sky high and then in 2012, it calmed back down closer to the generic 3%.
- Don’t alter your investment allocations to become riskier to make up for lack of funds or for lack of return. This is ultimately just going to get you in more trouble if there’s a bigger crash or something changes in your life circumstances. Don’t go riskier while you’re in retirement on your investments.
- If you are already in retirement you want to evaluate each and every single year what you really need to take from your nest egg. Not what some rule says that you can take out, but what you really, really need.
Everything that you can leave in your account now, you will have access to later. And one of the most often overlooked aspects of retirement planning is that you spend more at the very end on healthcare and end of living expenses. So you want to keep the money in there for as long as possible.
While there’s lots of generalized rules out there to make things easier for us when doing our financial planning we need to remember they are only guidelines and should not be blindly followed. Instead, we need to sit down, take the time to look at our own financials and our own situation and make decisions based on our own needs.
If you are within five years of retirement, I recommend you read this book: How Much Money Do I Need to Retire?