All sorts of questions flood your mind once you begin to think about retirement. Do I have a large enough nest egg? How high of a return do I need? When do I begin social security? All of these are important pieces to the retirement puzzle.
Since ever-increasing life expectancies are extending retirements to 25-30 years, don’t forget one of the most important pieces of the puzzle: “How much can I withdraw each year from my nest egg to meet living expenses without running out of money?” To answer this, most people rely on the 4% rule. Why? Because they’ve either heard or read somewhere the 4% rule provides a good “guess” and is a good “rule of thumb” for calculating the amount.
When it comes to something as important as a retirement plan, especially one you want to have confidence in, “guesses” and “rules of thumb” are unacceptable. Take the guesswork out of your retirement planning by using modern tools such as the Relax Retirement Planner to answer all of your financial retirement questions. It puts together all the pieces of your retirement puzzle quickly and easily.
The 4% rule is obsolete
The 4% rule, developed by financial advisor Bill Bengen in about 1994, is a general rule of thumb for determining how much of your nest egg can be withdrawn each year without the fear of running out of money in a typical 20-30-year retirement. The procedure is to multiply your nest egg by 4% to derive the first year’s withdrawal amount. Then, withdraw the same dollar amount each year thereafter, but increase this dollar amount by the rate of inflation (the original 4% calculation is done only once).
So, what’s the math that enables the 4% rule to work over a lengthy retirement period? It assumes your nest egg is invested and will generate a real (adjusted for inflation) return of 4% annually. The 4% return is derived from the 7% historical annual return generated by the market over the long term (30-40 years), less inflation.
The 4% guideline has been used for years, but it is not without limitations and drawbacks. For example:
It neglects a key piece of the puzzle. Mathematically speaking, applying the 4% rule can enable your retirement fund to last about 30 years, but you should read the fine print. The rule does not guarantee or mean that withdrawing 4% will be enough to fund your annual expenses. See, the rule does not factor in how large a nest egg should be to live comfortably. For example, let’s assume your nest egg totals $100,000. Excluding inflation, the 4% rule means you can withdraw $4,000 each year for about 30 years. Unfortunately, $4,000 will likely not cover your monthly expenses let alone your annual expenses. Accordingly, the 4% rule neglects a critical piece of the retirement puzzle.
It may shortchange your retirement. The 4% rule does not consider other forms of retirement income such as social security, pensions, or part-time jobs. This drawback could lead to an unnecessarily frugal retirement and a windfall for your heirs. That’s because having other sources of income may mean that your nest egg does not need to last 30 years and withdrawing only 4% each year may not deplete your nest egg at all, leaving a large windfall for your heirs. Of course, there is nothing wrong with that, but It may unnecessarily deprive you of many enjoyable luxuries.
Its assumptions may be outdated. The data that went into determining the 4% rule may be outdated. For example, the rule assumes your nest egg earns the market’s historical rate of return. Be aware that some analysts believe market returns over the next 10 years may be below historical averages due to low inflation, low interest rates and above-average equity valuations. In addition, the 4% rule assumes a 50%/50% allocation between stocks and bonds. Given that the long-running bull market in bonds (because of declining interest rates) may be ending, this asset allocation mix may not yield the same results as it has historically. Lastly, the 4% rule does not factor in the likelihood of having to spend significantly more in a given year for unforeseen large expenses such as medical care.
The right retirement calculator can replace “rules of thumb”
The 4% rule is a “one-size-fits-all” approximation of how much you can withdraw from your nest egg during retirement. Eliminate the guesswork and get a customized retirement plan by using modern tools such as the Relax Retirement Planner.
In a quick and easy fashion, this planner takes all of the relevant inputs and projects how long your savings will last. No guesses, no rules of thumb, no approximations. Just facts you can have confidence in. It will tell you exactly how much you can withdraw and not run out of money in retirement.
It’s not necessary to use old-fashioned, outdated tools and hope they are appropriate for you when planning for your retirement. By the time you find out they’re not, it may be too late to make changes. Take the guesswork out of your retirement planning.