It May Be Time to Rethink the 4% Retirement Rule

A 4% withdrawal rate could be too aggressive for today’s environment.

There are two rules of thumb that many people have traditionally followed to guide their retirement savings: The 80% rule and the 4% rule.

The 80% rule focuses on how much you’ll need yearly, advising people to have 80% of their pre-retirement yearly income in retirement to maintain their lifestyle. The idea behind the 4% rule is that retirees could plan to withdraw 4% of their retirement savings yearly for 30 years (adjusting for inflation) without outliving their savings.

The 4% rule is best used alongside the 80% rule because it tells you the total amount you should have saved for retirement. All you have to do is multiply your ideal yearly income by 25. For example, if you currently make $80,000 — meaning you’ll need $64,000 yearly in retirement — you would aim to have at least $1.6 million saved for retirement.

Ideally, a retiree would withdraw 4% of their savings in year one and then adjust the withdrawal amount for inflation in the following years. For example, if you had $1.6 million saved in your first year, you would withdraw $64,000 that year. If inflation rose by 2% the following year, you’d then withdraw $65,280.

Things are a bit different now
The problem with the 4% rule now, unfortunately, is that it may not be as useful a baseline with current inflation and economic conditions. Even after decreasing from a 40-year high, the annual inflation rate ending in July was 8.5%. Increasing your withdrawal amount by this much to keep up with inflation could increase the chances of you outliving your savings.

If you withdrew $64,000 in your first year of retirement and then adjusted for the 8.5% rate of inflation, you’d withdraw $69,440 in your second year. There’s no reason to believe that historically high inflation rates will continue for years, but it’s always better to prepare for the worst and hope for the best, especially with so much uncertainty right now. Even the creator of the 4% rule, Bill Bengen, cautioned against using 4% in today’s environment, telling the Wall Street Journal that “the problem is that there’s no precedent for today’s conditions.”

Morningstar recently did a study that suggests retirees should use 3.3% as their initial withdrawal rate. This would give someone with 50% of their portfolio in stocks and 50% in bonds a 90% degree of certainty that they won’t run out of savings over a 30-year span. The higher a degree of uncertainty you’re willing to take on, the closer to 4% you can go.

It’s all about being flexible
More than anything, a successful retirement is about being able to adjust to the current conditions while keeping your long-term goals in mind. Unfortunately for some people, this will mean decreasing their yearly withdrawal (at least initially) and cutting back on spending. It may not be preferable, but it’s a better alternative than outliving your retirement savings and potentially having to go back to the drawing board.

Nobody can predict the future. But you can make sure you’re leaning toward being overprepared rather than underprepared.

— Stefon Walters

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Source: The Motley Fool