Why the 4% Rule for Retirement Won’t Work Anymore

When planning for retirement, many people like to look for simple rules to follow. There are plenty out there — one of the most common is the 4% withdrawal rule. It states that you can comfortably withdraw 4% of your savings in your first year of retirement and then adjust that amount for inflation for every subsequent year, and thus avoid running out of money for at least 30 years.

It sounds great in theory, and it may even work for some in practice. But if you’re blindly following this formula, you could still end up running out of money prematurely or with a financial surplus at the end of your life that you could have spent on things you enjoy.

The problems with the 4% rule

As with many of these so-called retirement rules of thumb, the 4% rule aims for simplicity but isn’t flexible enough for a wide range of scenarios. It assumes that your investment portfolio contains about 60% stocks and 40% bonds, but your assets may be allocated differently. Investing more in bonds could result in slower investment growth, because bonds typically don’t see the returns that stocks do, and when the 4% rule was developed, bond interest rates were much higher than they are today. Following the 4% rule in this scenario could cause you to withdraw too much too quickly.

The rule also doesn’t account for changing market conditions. In a recession, it’s probably not wise to step up your withdrawal amounts; you may even want to reduce them slightly. But when the markets are doing well, you might be able to withdraw more than 4% comfortably.

A third issue is that it doesn’t account for changes in spending and activity levels throughout your later years. Most retirees are more active in the early part of retirement. They often devote more time to hobbies or travel, and their spending is often higher than when they’re beginning to slow down and spend more time closer to home.

But the 4% rule isn’t dynamic enough to account for these lifestyle changes. It limits you to a pre-set amount, which may be too little in your early years and too much in your later years. As a result, you end your life with a bunch of money left over and you weren’t able to enjoy your early retirement as much as you’d wanted to.

How to figure out how much you can spend annually in retirement

There are other retirement withdrawal strategies that are slightly more dynamic than the 4% rule. The Center for Retirement Research at Boston College proposed a system in which you base your annual retirement withdrawals off the IRS required minimum distributions (RMD) tables. RMDs are the amounts you must begin taking from all retirement accounts except Roth IRAs once you’re 70 1/2, unless you’re still working and own no more than 5% of the company you work for. You divide your account balance by the distribution period next to your age in this table to figure out how much you must withdraw every year. 

The Center for Retirement Research used this as its jumping-off point and calculated annual withdrawal amounts as a percentage of your total account balance beginning at 65 — when it claims you can safely withdraw 3.13% of your retirement savings — until age 100, when you can withdraw 15.67%.

This formula has some of the same flaws as the 4% rule. Changing market conditions may affect what you can safely withdraw, and you’re limited to smaller amounts when you’re younger and may want to spend more. But you could make up for this somewhat by spending any earned interest and dividends in addition to the percentages recommended. 

An even better approach is to ignore the cookie-cutter strategies altogether. Talk to a financial adviser about your plans for retirement and how they will affect your spending habits. An adviser will help you determine how much you need to save and how much you can comfortably spend each year to avoid running out of money too soon. 

Make sure you choose a fee-only financial adviser. Those who earn commissions when you buy certain investments can make recommendations based on their bottom line rather than your best interests. Always ask for a copy of an adviser’s fee schedule so you understand what you’re signing up for.

The 4% rule can be a useful starting point to determine how much to spend annually in retirement, but be aware of its limitations. Your needs and goals in your later years are dynamic, and you need a withdrawal plan that is, too.

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