You may, or may not, have heard of the 4% rule for retirement income. It goes like this – you start with 4% or your retirement savings as your first year’s income (divide by 12 to get the monthly amount). Then you add 3% to your initial dollar amount the next year for inflation. Then you add 3% to that for the third year’s income. You keep adding 3% to the prior year’s income.
So … that works, until it doesn’t. What is wrong? Really, the first problem is increasing how much you take out each year for income without any reference back to what your portfolio balance is. If you keep taking an ever increasing amount out of your pot without considering how much you have left in the pot after you take it out, you may soon run out of money in the pot. A formula for disaster.
The second problem – the research that came up with that number was based on your early retirement years (the distribution periods were 30 years long). It is a rule that was tried to be applied to all retirees of all ages. That 4% number is pretty close if you are in your early 60’s. However, if you look at the slide below, it can actually be higher as you age.
How can it be higher if the 4% rule doesn’t work? Isn’t that risky? No!
Well, in the first place, the withdrawal rate doesn’t have anything to do with your balance … it is only applied to your balance once you have determined what it should be for your present age. The withdrawal rate has everything to do with how many years you may have left in life. How many years you may have left should be determined by referring to what’s called a Period Life Table. You can’t just divide you pot of money by how many years left though because, as you age, how many years you have left doesn’t go down by 1 for the year that just passed. No matter how old you are, you still have years remaining! At least statistically – expected longevity is when half of those at a given age don’t make it … the other half do. You don’t know which half you will be in by that expected longevity age (above the ground, or below the ground), except you are in the above the ground half when you still need income for next month’s expenses! So you have to apply a prudent percentage to your portfolio balance, based on your age, instead of trying to divide by years you have left. These percentages come from research that looked into how to manage retirement resources into very old age (in other words, so you may not outlive your money).
In the second place, you need to keep how much you take out of the retirement pot connected to how much money there is in the pot. The percentage you take out can go up as you age. But that percentage is applied to your portfolio balance that year to give you a dollar number you can spend that year. Yes, some years you can spend more, and other years you should be careful or spend less (but, it was that way when you were young and working too!)
Notice in the graph below that the more aggressive allocations are below the red line. The higher withdrawal rates at any given age correspond to less stock (equity) and more bonds. As you age, having less exposure to stocks means less volatility or fluctuation in portfolio values … that helps you, not hurts you. Stocks provide growth when you are young, and bonds provide income when you are older. You still need some stocks to get growth you need for the years you have still have ahead of you though (this goes to the first place point above). That allocation mix changes slowly as you age too.
Seeking a single number that is universal to everyone like the 4% rule won’t work. People’s situations are different, especially ages. How much Social Security you have and if you have a pension or not are also factors. A simple rule doesn’t cut it. That rule is the result of trying to over simplify a complex matter. You need to customize retirement to your specific situation. Customization fine tunes your retirement and annual reviews keeps your income connected to your portfolio. If you try to over simplify things, you actually increase the risk of running out of money too soon.
As in medicine, for somethings you don’t want just any surgeon, you want one who specializes specifically in what you need to have done. Retirement income is not a set-and-forget item. It needs care and annual check ups.
4% Rule is now gone blog (yes I said this back in 2012 – and even before that with research findings).
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