One of the most important aspects of planning for your transition into retirement is your strategy for withdrawing money from your nest egg. This will be the amount you need to bridge the gap between what you receive from sources like Social Security and perhaps a pension and the amount you will need to support your desired lifestyle each month during retirement.
Planning and executing your retirement withdrawal strategy can be the difference between a financially successful retirement and one that isn’t.
The 4% Rule
One of the financial world’s most iconic rules of thumb is the 4% retirement withdrawal rule. It is also one of the most misunderstood.
The 4% rule is the brainchild of retired fee-only financial advisor Bill Bengen. On a personal note, I had the opportunity to see him speak at an industry conference a few years ago, and he is one of the best and brightest advisors of the financial services industry.
Bengen’s premise was that a balanced portfolio could reasonably be expected to support a withdrawal rate of 4% of the initial balance over a 30-year retirement. For a portfolio with an allocation of 20% or more to equities, the success rate, defined as not running out of money over this 30-year time horizon, exceeds 90%.
The 4% Rule Math
The math for the 4% rule might go something like this:
Retirement nest egg: $1 million
Planned annual spending in retirement: $80,000
Let’s assume this is a married couple who both worked prior to retirement.
In this case the initial $1 million nest egg would be assumed to produce $40,000 in gross annual cash flow. The other $40,000 might come from the couple’s Social Security and/or perhaps a pension if either of them was covered by one at their jobs.
Hard Rule or Rule of Thumb?
In my opinion, rules like the 4% rule are valuable as estimating tools. The 4% rule is a good “back of the napkin” estimating tool to determine if you are on the right track toward having a sufficient nest egg to last through your retirement.
For example, if you are looking to retire in, say, 10 years you can look at what you have accumulated, Social Security estimates, etc., to see what your likely retirement cash flow looks like. You can then decide if this calculation is in line with what you think you will need in retirement. The amount you are saving for retirement is a factor as well.
This allows you to get a preview of where you are or where you are trending to in terms of your retirement.
If it looks like you will be coming up short, the longer you have until retirement, the more time you have to make adjustments. Can you save more? Might you work longer or perhaps phase into retirement by gradually ramping down the amount of time spent working instead of leaving your job cold-turkey? Do you need to rethink your retirement lifestyle and downsize it a bit?
As far as being a hard and fast method to manage your retirement withdrawals, the 4% rule, or any rule of thumb based method, comes up a bit short. The better method is to do actual calculations up front and adjust them each year based upon investment results and other factors including unexpected expenditures that may occur in a particular year.
Longevity and the 4% Rule
Bengen assumed a 30-year retirement period. In today’s world of increased longevity, as well as some people striving for early retirement, a 30-year time span may not be long enough. Your calculations and your withdrawals may need to reflect the added stress a longer life expectancy can have on your nest egg.
Craig Israelsen, a financial planning expert, uses another rule, the retirement account multiple (RAM). The premise of RAM is to calculate a retirement savings amount in terms of your final salary prior to retirement.
If your final salary is $100,000 and you had $500,000 saved for retirement, then your RAM would be 5. Israelsen estimates most 65-year-olds need a RAM in the 7 to 18 range in order to have a shot at not outliving their money before age 100. A RAM of 7 equals a 71% chance at not outliving your money; a RAM of 18 means you would certainly not outlive your money out to age 100.
In order for those who are not yet near retirement, you would need to estimate what your ending salary might be. You could then attach different RAM multiples and finally see what that equates to versus your current level of retirement savings.
Considerations in Planning a Withdrawal Strategy
Your retirement withdrawal strategy needs to take a couple of factors into consideration:
Inflation. Even though inflation is at historically low levels currently in terms of broad-based indicators like the consumer price index (CPI), the basket of goods retirees spend their money on doesn’t necessarily conform to the CPI. Case in point is health care in retirement, which continues to rise at a rate faster than inflation. A 3% rate of inflation, normal by historical standards, would cut your purchasing power in half within 24 years.
Market volatility. While most retirees cannot just stick their money in the bank and hope to outpace inflation, an investment strategy that balances the need to keep pace with inflation with a buffer against market volatility is key.
These two sometimes conflicting factors need to be considered in formulating a retirement withdrawal strategy. Instead of a hard and fast percentage, you may need to vary the amount withdrawn and have the ability to plan accordingly in terms of your spending and lifestyle. Having one to three years’ worth of anticipated withdrawals in cash or very safe investments is a good idea, as this will keep you from having to sell investments during steep market declines.
Rules of thumb are everywhere in the financial planning world. The 4% rule has endured for many years and has been maligned in the press from time to time. This or any rule of thumb may have value as a quick estimating tool. No rule of thumb is a substitute for diligent planning and number crunching when it comes to retirement.