The 4 percent rule, which is used to determine how much you should withdraw from your retirement account each year so you don’t outlive your savings, is much loved by some and much hated by others. How effective is it, really?
How it works is simple but often misunderstood. You don’t withdraw 4 percent of your retirement savings each year in retirement; you withdraw 4 percent in the first year of retirement. In subsequent years, you increase the value of your annual withdrawal by the inflation rate.
So, as an example, if you have $2 million in retirement savings, you would withdraw $80,000 in the first year (4 percent of $2 million). Then, in the second year, when the inflation rate is 2 percent, you would withdraw $81,600 (the original $80,000 plus 2 percent).
But the 4 percent rule is more of a guideline than an absolute. The rule is intended to provide a schedule of withdrawals that will ensure that your retirement savings will last at least 30 years. When William Bengen developed it in the 1990s, that seemed to be the case. But some financial planners now argue that the 4 percent rule might not provide the same margin of safety as it did in the past, since stock returns and bond yields have declined since the 1990s.
The fact is, it has always been impossible to know with absolute certainty that the 4 percent rule will prevent you from outliving your retirement savings. Even the most careful planning cannot account for every scenario and surprise.
So how do you choose a withdrawal rate? It may be more art than science. Start with the 4 percent rule; but if you seem to be running through your savings too quickly, withdraw less. If you seem to have some wiggle room, withdraw more. Continue to monitor your investments and make adjustments as needed.
It’s certainly a conversation worth having with a financial professional who knows your individual financial circumstances and goals. This expert can help you fine-tune your retirement withdrawals to achieve a healthy balance between spending and saving.