Recently Money Magazine ran a story entitled ‘Does the 4 percent rule for retirement withdrawals make sense?‘ where they entertained a reader’s question about whether or not this widely popular advice holds any validity or not.
The 4 Percent Rule Theory:
For those of you who don’t know, the idea behind the 4 Percent Rule goes like this:
• Spend your life building up your retirement savings (also called your “nest egg”). For example: Let’s say you save $1,000,000.
• When you retire (stop working), you still need money to live on. So you withdraw a small percentage of your nest egg. To follow the 4% Rule, you’d withdraw $40,000 from your retirement savings to use for living income.
• If you believe that the markets will continue to return the average of 8% (which is highly debatable), then meanwhile your $1,000,000 will grow to be $80,000.
• If that is true, then your nest egg grew by a net amount of $40,000 ($80,000 – $40,000). So in theory if this cycle were to continue, your retirement savings would last you forever (again, HIGHLY debatable).
Unfortunately, It’s Just Not That Easy:
To borrow a line from the article, if only “life unfolded with the predictability of a spreadsheet”.
The major take-away from this Money Magazine article is that:
• You should approach the 4 Percent Rule as more of guideline and less of a hard number to live by.
I can agree with this statement due to a variety of reasons:
• The 4 Percent Rule only has a 90% probability of for your money lasting 30 years. What if you need the money longer?
• The markets will never return a perfect 8% every year. They will be up, down, and neutral some years. This will affect the sustainability of your money.
• Even if the markets do well, the portfolio selection for your retirement savings (amount of stocks, bonds, cash, etc) as well as the expense ratios will determine what actual net percentage return you make.
• If you plan to have other retirement income sources such as a pension, rental income, Social Security, etc, then you may not need that much money from your retirement nest egg. Going back to our example, perhaps you really only need $20,000 of that $1,000,000.
• Inflation will also impact effective purchasing power of your money which may alter your needs.
Not too long ago I ran a post entitled “Is 2 Percent the New Safe Retirement Withdrawal Rate?” that attempted to dive deeper into the 4 percent rule by crunching some numbers. To my surprise, the post attracted a lot of attention and received some very valuable commentary.
However, to generalize a withdrawal rate to use for modeling, my opinion still remains to keep this value no more than 3%. By reducing this number down, I feel as though you create an inherent safety margin that will keep your money from disappearing so quickly. In fact, I’d like to see this percentage reduced down even further by supplementing my retirement income with other creative forms of passive income.
Try It Yourself:
Not convinced? Want to try out your own figures? I recommend using a Monte Carlo simulation to see how you would fare. A Monte Carlo simulation is where you use completely random sets of numbers (given between two boundaries) to simulate what the stock market will do and see if your portfolio withstands the test of time.
Please feel free to visit my article “A Better Way to See If You’ll Run Out of Money During Retirement” where you can download my Excel spreadsheet to try this for yourself.
1) Six Easy Steps to Figuring Out Your Retirement
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