Getting Real: The 4% Rule for Retirement Savings Withdrawals
If you start talking with anyone – your financial advisor, someone who reads the financial press, maybe even your dog – about how much you can withdraw from your savings when you retire, you’re likely to get an answer revolving around “The 4% Rule.”
This rule is not a real rule, just a “rule of thumb.” It’s based on a string of technical studies addressing the question: how much could you safely withdraw every year, with an allowance for inflation, and (probably) not run out of money before you die?
The answers vary depending on the methods and the data used in each study, but generally fall in the 3.5% to 4.5% percent range, with 4% being the most popular as well as the average result. So for quite a while now, financial people have been talking about the 4% Rule with some degree of confidence.
It means that if you have $100,000 saved for retirement, and you invest it moderately aggressively (say, 60% stocks and 40% bonds) you can withdraw $4,000 the first year, and a little bit more (for inflation) the next year. Even if the markets fall, you can still take that original $4,000-plus-inflation, because market fluctuations are built into the model. Then again, if the markets soar, you should still take only the planned amount, because eventually the markets will drop again.
But the recent recession has demonstrated that the 4% Rule is too aggressive. Recently, several new studies have shown that, for various reasons, 3%, 2%, or possibly even less is a “safe” withdrawal. And even then, the studies are based on the idea that “safe” means maybe a 1-in-20 chance that you’ll still outlive your savings.
Why are the results so grim? Partly this: when you invest in the stock and bond markets, you’re exposed to a lot of risk. Because of that risk, playing it safe (which most retirees want to do) means withdrawing less than would probably work out.
There are also some technical problems with the mathematics of the 4% Rule. But the biggest problem is that it’s a rule that sounds helpful, but is almost useless in real life. Most people will be retired at least 20 or 25 years, and many will last 30 or 40 years, or even longer. In that span of time there is about zero chance that your needs for retirement cash will follow an uninterrupted path. Instead, most people will have big changes – for example, if you still have a mortgage when you retire, your cash needs will go way down once it’s paid off.
So the 4% Rule almost inevitably recommends an initial withdrawal rate that’s too high or too low. If it’s too high, you’re either going to run out of money too soon, or you’ll have to take a big hit to your lifestyle later. If it’s too low, you’ll eventually realize you have more money than you need and you can start spending more, but it’s much better to know this when you still have the health and energy to enjoy it.
So if someone starts talking about the 4% Rule as a good strategy, this tells you two things. First, they’ve been paying attention to what’s happening out there in financial planning land. Second, they lack either the knowledge or the tools to give you the tailored financial advice you actually need.
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