The 4% rule answers a question every retirement investor asks at some point: How much can I afford to withdraw each year from my savings, so that I don't run out of money? While it's great for planning to have an easy answer, there's one big problem: The 4% rule may need to retire before you do.
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A financial advisor named William Bengen first published the4% rulein the 1990s. He identified his now-famous safe withdrawal rate after running multiple scenarios against the actual financial market returns and inflation rates between 1926 and 1992. His analysis led to a surprisingly simple conclusion. Even through history's worst crashes and economic downturns, portfolios containing 50% equities and50% bonds did not run out of money for 30 years or more when withdrawals were capped at 4% with annual adjustments for inflation. Since Bengen's initial analysis, othershave replicated his work with more-current data to verify that the rule still holds up.
Longer life spans, more volatility
So, what's the problem? Although the 4% rule may hold its weight on paper currently, the future's likely to bring conditions that haven't been baked into the analysis. One concern is the timeline. People are living longer, and 30 years of solvency may not be enough. To be fair, life spans would have to get a lot longer to break the 4% rule on their own. In many of Bengen's scenarios, the portfolios actually had a higher balance after 30 years thanat retirement.
But there is another issue: The 4% rule assumes future market conditions will be no more extreme than historic ones. The downturns covered in Bengen's analysis did include the Great Depression and the 1973-1974 stock market crash, which admittedly were pretty extreme. Even so, given how 2020 has played out thus far, it doesn't seem wise to assume we won't set new records sometime down the road.
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This year has already produced historicallylow bond yields, which fall outside Bengen's analysis. That alone is significant, given that he initially assumed a portfolio with 50% bonds. Plus, 2020 has also delivered some historically significant moves in the equities market. The coronavirus-fueled sell-off in March was the fastest 30% drop in history. As well, the single-day dip on March 16 was theS&P 500'sthird-largest single-day percentage drop in history.
It's these never-before-seen market conditions along with longer life spans that threaten to break the 4% rule.
Unfortunately, when it comes toretirement planning, you have to address the worst-case scenario. It's not enough to be 90% sure you won't run out of money in retirement; you have to be 100% sure. And that level of confidence requires very conservative planning. In today's world, the 4% withdrawal rate may not be conservative enough.
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A lower withdrawal rate requires higher savings
Mathematically, lowering the withdrawal-rate assumption in your retirement plan means you have to save more before retirement or spend less after retirement. And the change can be significant. The table below shows how your target savings balance varies based on 3%, 3.5%, and 4% withdrawal rates, as well as how much income you need from the retirement account in your first year.
As you can see, if you plan to take $40,000 from your retirement savings in the first year, changing the withdrawal rate from 4% to 3% raises your starter-savings needs by more than $300,000. If you want to pull six figures annually from your savings in retirement, you may have to save an additional $830,000.
If you don't want to increase your savings target, you can hope for the best (not recommended as your entire strategy) or plan for a more subdued lifestyle later. If you're on track to save $2.5 million, for example, the percentage-point-lower withdrawal rate lowers your income from $100,000 to $75,000 in that first year.
Get conservative with your retirement plan
Over the past 25 years, the 4% rule has helped many retirement investors plan their savings goals and manage their account withdrawals. But as people live longer and the markets outdo historic extremes, a 4% withdrawal rate will be less reliable. Now's the time to think through what your retirement plan looks like with a 3% or 3.5% withdrawal rate instead -- so you have the time to adjust your savings plan as needed.
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FAQs
The 4% rule comes with a major caveat: It's not really a “rule” since everyone's situation is different. If you have a large retirement investment portfolio, you might not need to spend 4% of it every year. If you have limited savings, 4% might not come close to covering your needs.
What are the flaws of the 4% rule? ›
Image source: Getty Images. But I have a couple of problems with the 4% rule. First, it assumes a fairly even mix of stocks and bonds, which not all retirees have. Also, it relies on fairly strong bond yields.
What is a safe withdrawal rate for a 70 year old? ›
Description: The 4% rule suggests that retirees can safely withdraw 4% of their retirement portfolio balance each year without depleting their savings over a 30-year period. Rationale: This rule is based on historical market performance and assumes a balanced portfolio of stocks and bonds.
How many people have $1,000,000 in retirement savings? ›
According to the Federal Reserve's latest Survey of Consumer Finances, only about 10% of American retirees have managed to save $1 million or more.
How much does Suze Orman say you need to retire? ›
Famed financial guru Suze Orman once told Paula Pant on the “Afford Anything” podcast that $2 million simply isn't enough to retire early on. So, how much does she say you will need to live comfortably in your golden years? She advocates saving significantly more — closer to $5 or $10 million in order to retire early.
What percentage of retirees have $2 million dollars? ›
According to EBRI estimates based on the latest Federal Reserve Survey of Consumer Finances, 3.2% of retirees have over $1 million in their retirement accounts, while just 0.1% have $5 million or more.
Is the 4 rule too conservative? ›
However, those who have can withstand more market fluctuations may have more flexibility with withdrawal rates. For those retirees, the 4% rule likely will provide an outdated recommendation. “It's going to be too low for most people who are retiring at a reasonable age,” Blanchett said.
Where did the 4 rule come from? ›
How the Four Percent Rule was Created. The four percent rule stems from historical data on stock and bond returns over the span of 50 years, between the periods of 1926-1976. Before the 1990s, many individuals believed that 5% was the appropriate benchmark value that retirees should've withdrawn each year.
What is the No 4 rule? ›
One frequently used rule of thumb for retirement spending is known as the 4% rule. It's relatively simple: You add up all of your investments, and withdraw 4% of that total during your first year of retirement.
Can I retire at 62 with $400,000 in 401k? ›
sort of. At age 62, with $400,000 in a 401(k) account, you can generate a livable income depending on how you structure your portfolio and where you choose to live. Livable does not mean comfortable, however.
This money will need to last around 40 years to comfortably ensure that you won't outlive your savings. This means you can probably boost your total withdrawals (principal and yield) to around $20,000 per year. This will give you a pre-tax income of almost $36,000 per year.
How long will $500,000 last in retirement? ›
Summary. If you withdraw $20,000 from the age of 60, $500k will last for over 30 years. Retirement plans, annuities and Social Security benefits should all be considered when planning your future finances. You can retire at 50 with $500k, but it will take a lot of planning and some savvy decision-making.
What is considered wealthy in retirement? ›
According to the SCF report, it takes a net worth of $16.7 million or more for those over 65 to be considered super wealthy. People at this level “engage in just about anything they want to engage in,” says Schmidt.
What is a good net worth to retire? ›
By age 40, you should have accumulated three times your current income for retirement. By retirement age, it should be 10 to 12 times your income at that time to be reasonably confident that you'll have enough funds. Seamless transition — roughly 80% of your pre-retirement income.
Can a couple retire on $1 million dollars? ›
How long will $1 million in retirement savings last? In more than 20 U.S. states, a million-dollar nest egg can cover retirees' living expenses for at least 20 years, a new analysis shows. It's worth noting that most Americans are nowhere near having that much money socked away.
How long will the 4% rule last for retirement? ›
What does the 4% rule do? It's intended to make sure you have a safe retirement withdrawal rate and don't outlive your savings in your final years. By pulling out only 4% of your total funds and allowing the rest of your investments to continue to grow, you can budget a safe withdrawal rate for 30 years or more.
Is the 4% retirement rule making a comeback? ›
Ivanna Hampton: New retirees could kick off their golden years with a familiar number, 4%. A trio of Morningstar researchers analyzed starting safe withdrawal rates from an investment portfolio to fund retirement. The future looks good, and a little flexibility could make it even better.
Does the 4 rule work if you retire early? ›
And the rule may be inadequate for early retirees who may spend 50 years in retirement. With a 4% withdrawal rate, going from a 30-year to a 50-year retirement horizon decreases the probability of success from 81.9% to 36.0%.
What are the alternatives to the 4% rule? ›
Adjustments And Alternatives To The 4% Rule
Alternatives include dynamic spending strategies and a reliance on a total return approach rather than a strict withdrawal percentage, adapting to market fluctuations and personal circ*mstances.
