fbpx

Here Are the 4% Retirement Rule’s Major Flaws

The 4% rule can be fine as a general rule of thumb, but follow it rigidly and you might run into trouble.

Thinking about retirement can be stressful. Most of us need to come to reasonable estimates of how much money we should accumulate before retiring — and then we have to have plans for withdrawing funds from our nest eggs during our retirement so that we won’t run out of money. Many people find the “4% rule” helpful, as it can tell you how much you’ll need to retire with and how much to withdraw each year. Unfortunately, it has some drawbacks.

Meet the 4% rule

The 4% rule was introduced by financial advisor Bill Bengen in 1994 and was made famous in a study by several professors at Trinity University a few years later. It says that you can withdraw 4% of your nest egg in your first year of retirement, adjusting future withdrawals for inflation. This withdrawal strategy assumes a portfolio 60% in stocks and 40% in bonds, and it’s designed to make your money last through 30 years of retirement.

Here’s an examples of how it works: Imagine that you’ve saved $600,000 by the time you retire. In your first year of retirement, you can withdraw 4%, or $24,000. In year two, you’ll need to adjust that rate by inflation. Let’s say that inflation over the past year was at its long-term historic rate of 3%. You’ll now multiply your $24,000 withdrawal by 1.03 and you’ll get your second year’s withdrawal amount: $24,720. The following year, if inflation is still around 3%, you’ll multiply that by 1.03 and get your next withdrawal amount, $25,462.

The rule can also help you determine how much you’ll need to accumulate in the first place once you know how much annual income you’ll want in retirement. Let’s say, for example, that you’d like total income of $60,000, and you expect to collect $25,000 from Social Security. That leaves $35,000 in income that you’ll need to generate on your own. If you assume that $35,000 is 4% of your nest egg, then you can multiply $35,000 by 25 in order to arrive at the size the nest egg will need to be: $875,000. (Why 25? Because one divided by 0.04 is 25.)

So what’s the problem with this seemingly perfect rule? Well, a bunch of things.

Getty

IMAGE SOURCE: GETTY IMAGES

Trouble in paradise

Let’s start with the fact that the rule was created more than 20 years ago, when interest rates were higher. In such an environment, the bond portion of a portfolio would have been generating more income. We’ve been in a low-interest rate environment for a long time now, rendering our bonds less able to replenish funds withdrawn each year.

Then there’s the rule’s assumption that your portfolio will be split 60-40 between stocks and bonds. You might not have or want that allocation. If your portfolio is split 50-50, or you have 75% of it in stocks, then the 4% rule won’t work as advertised.

Meanwhile, many people are living longer. Data from a 2015 Centers for Disease Control and Prevention report shows that those born in 2014 can be expected to live, on average, to age 78.8, up from 75.8 in 1995 and 70.8 in 1970. And those are just averages — many people live much longer (and some much shorter) lives. The 4% rule aims to make your money last for 30 years, but if you retire at 62 and live to 96, you might be quite pinched in your last years.

Finally, remember that every set of 20 or 30 or however many years in the stock market will be at least somewhat different — some with higher-than-average gains and some with lower-than-average gains. If you plan to follow the rule and withdraw 4% of your nest egg in your first year of retirement, what if the stock market and your portfolio tank by 30% in the year leading up to your retirement? Such things can happen — the S&P 500 plunged 37% in 2008. If that happens early in your retirement, you’ll either be withdrawing far less than you’d planned on or you’ll be depleting your nest egg faster.

Getty Retirement Plan

IMAGE SOURCE: GETTY IMAGES

What to do

Fortunately, you don’t necessarily have to throw out the 4% rule altogether. You can address the stock market-volatility issue by being flexible. Withdraw less than 4% in bear markets and more than 4% in bull markets.

If you think you stand a decent chance of living more than 30 years in retirement, you can be more conservative, perhaps using a 3% or 3.5% withdrawal rate — at least in your initial years. That can be helpful during our low-interest rate environment, too. (Many expect rates to inch up in the coming years, though that’s far from guaranteed.) You needn’t be too rigid about it, though. If the market grows briskly in your first few years, you can reevaluate and perhaps up your withdrawals.

It’s a good idea to reassess your financial condition regularly during your retirement, anyway. For example, if when you’re 80 you don’t think you’ll be around in a decade and your coffers are rather full, you could start withdrawing and enjoying more each year — or just plan to leave more to your loved ones.

Consider buying one or more fixed annuities, too. (Avoid variable or indexed annuities, and focus on ones promising fixed payouts.) With a fixed annuity, you fork over a big chunk of money to an insurer and in exchange, you can receive regular payments — for the rest of your life. This can be a huge psychological relief as you get older, removing the worry of running out of money and removing the responsibility of having to manage and invest some or much of your money, too. It’s also sensible to consult a financial planner about your retirement plans, too — ideally a fee-only one and not one who benefits from commissions by selling you products.

The 4% rule isn’t useless, but if you’re going to use it, do so thoughtfully — and perhaps consider it a rough guide rather than a firm rule.

The $15,834 Social Security bonus you could be missing
If you’re like most Americans, you’re a few years (or more) behind on your retirement savings. But a handful of little-known “Social Security secrets” could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $15,834 more… each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we’re all after.  Simply click here to discover how to learn more about these strategies. 

Longtime Fool specialist Selena Maranjianwhom you can follow on Twitterowns no shares of any company mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

You May Also Like

Pride Week Festival Begins With Tribute to Pulse Nightclub Survivor

Miami Beach Pride’s week-long festivities will commence with a special tribute to the LGBTQ+ community honoring the victims of the tragic shooting at Pulse Nightclub in Orlando. A ceremonial “flip the switch” lighting event will illuminate the iconic 1111 Lincoln Road parking garage in pride colors as a sign of solidarity. It is the second

Surfside luxury condo sees notable sales

Arte at Surfside is making waves. There’s, of course, the news that Ivanka Trump and Jared Kushner are renting at the 16-resident luxury condominium. And there’s the December penthouse sale for $33 million. But other sales are heating up the oceanfront property at 8955 Collins Ave. developed by Alex Sapir and Giovanni Fasciano (both pictured

Up in the Air: A Discussion

In a dynamic region where residents are typically on the move, everyone is wondering about the health of the airline industry and the safety of airports and airplanes. Everyone is eagerly looking for signs about when air travel will begin to normalize. Against this backdrop of COVID-19, South Florida Business & Wealth organized a virtual

South Florida Yachting Legend Passes

Robert “Bob” Roscioli, an icon in the South Florida marine industry, has passed away. Many recognize the name Roscioli from the widely-successful and world-renowned Roscioli Yachting Center, a full service shipyard catering to South Florida’s marine industry. Bob built this business as a passion project, and because of his attention to detail and unique skill,

Other Posts

Four key steps

[vc_row css_animation=”” row_type=”row” use_row_as_full_screen_section=”no” type=”full_width” angled_section=”no” text_align=”left” background_image_as_pattern=”without_pattern”][vc_column width=”2/3″][vc_column_text] What a crazy time we are all experiencing. Right now, getting back to basics is most important. It is not and will not be business as usual right away. As leaders, you need to do the right thing to create an atmosphere of support with processes.

Pandemic adds to worries about hurricane season

An above-normal 2020 Atlantic hurricane season is expected, according to forecasters with NOAA’s Climate Prediction Center, a division of the National Weather Service. The outlook predicts a 60% chance of an above-normal season, a 30% chance of a near-normal season and only a 10% chance of a below-normal season. The Atlantic hurricane season runs from

The difference between leading and managing

[vc_row css_animation=”” row_type=”row” use_row_as_full_screen_section=”no” type=”full_width” angled_section=”no” text_align=”left” background_image_as_pattern=”without_pattern”][vc_column width=”2/3″][vc_column_text] Leadership and management are often misunderstood as one in the same. They are not. Certainly, a good leader should be able to manage and vice versa. But, it is important to understand the difference. Both are important to the success of an organization. The key difference

Flattening the housing curve in a pandemic

By Josh Migdal In the classic film Groundhog Day (and yes, it is a classic), Bill Murray’s character wakes up over and over again in Punxsutawney, Pennsylvania, reliving the same day for (presumably) eternity. Every morning, the alarm goes off at 6 a.m. playing I Got You Babe, assuring both the protagonist and the viewer