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About That 4%

Richard Quinn

IT’S SCARY TO RETIRE with a pool of money, knowing how you handle it determines your financial security for the next 25 years or so. It must seem even scarier to everyday Americans who don’t think they can count on Social Security.

A recent Tweet caught my eye. It linked to an article about the problems with the so-called 4% rule. As you might recall, the 4% rule states that, if you withdraw 4% of your portfolio’s value in the first year of retirement and thereafter step up the dollar amount withdrawn with inflation, you have a good shot at making your money last 30 years.

What’s the problem with the 4% rule? The article mentioned that people don’t spend the same amount each year, past investment results may not predict future returns and people’s finances could be upended by major life changes.

Meanwhile, others have argued that the rule is outdated. What’s the problem? Interest rates aren’t what they used to be, plus individuals may not feel comfortable with the assumed investment mix.

Getting worried? Yet other critics say the 4% rule results in retirees not spending enough, thereby leaving an unnecessarily large estate. I’m guessing that isn’t a problem for most. Still, it seems we have critics saying that the 4% rule leads to both too little spending and too much. Neat trick, wouldn’t you say?

I was particularly puzzled by the criticism that people don’t spend the same amount each year. If you’re living on a pension or Social Security, your spending will also vary from year to year. So why is this criticism directed at the 4% withdrawal rate? If you’re managing your own income flow, at least you have flexibility not found with a fixed monthly pension.

For many people, the key retirement planning question is, “How much income can I count on for the rest of my life?” Let’s assume you were earning $50,000 a year before you quit the workforce and you want that same income in retirement. First, subtract your Social Security benefit from the $50,000. That might leave you needing to generate $32,000 a year from savings. To that end, you could buy an immediate fixed annuity that’ll pay $32,000 a year for life. Today, that annuity would cost a 65-year-old man around $550,000.

Alternatively, you could manage the money yourself. Based on the 4% rule, you’d need to retire with $800,000 to generate $32,000. The good news: Unlike the annuity, the 4% rule should result in a growing income stream. For instance, after withdrawing $32,000 in the first year of retirement, you might pull out $32,960 in year two, assuming 3% inflation.

Still, there’s a tradeoff. With the annuity, you have guaranteed income for life—but you’ve turned over $550,000 to an insurance company and you’ve left yourself vulnerable to inflation. Meanwhile, with the 4% rule, there are no guarantees. Maybe your annual income will rise with inflation and you’ll leave excess funds to your heirs—or maybe you’ll run out of money and die broke.

Keep in mind that nothing says you have to withdraw the exact sum specified by the 4% rule. If you need less, take less. Alternatively, take the amount based on the formula from your long-term investment portfolio, but add some of the money to your emergency fund. That’ll give you a financial buffer if, say, we have a year with a significant market downturn and withdrawing the full amount specified by the 4% rule doesn’t seem prudent. Here are five additional pointers:

  • In addition to the nest egg you’ll use to generate income, aim to start your retirement with a reserve fund.
  • If you’re using the 4% rule, modify it annually based on your spending needs. Don’t need the full inflation increase? Don’t take it.
  • Make sure your living expenses are less than your expected income, so you have some wiggle room.
  • Budget for health care. It’s a big item, but not as big as some suggest. You see projections that retirees will spend hundreds of thousands on health care. Maybe, maybe not. The predictable annual cost is what matters. For most, that’ll be Medicare Part B and D premiums, plus Medigap premiums. Yes, Medicare does involve some modest out-of-pocket costs. But the real wildcard is long-term care. It won’t affect many, but those affected could face huge costs: About 2.4% of the population over age 65 is in a nursing home, though many of those are there on a temporary basis.
  • Consider combining an immediate annuity with retirement assets where you use the 4% rule. That way, you’ll have steady income from Social Security and the annuity—but you’ll still retain control of part of your nest egg.

As you navigate all of this, you will have the added complication of taking required minimum distributions (RMDs) from your retirement accounts. Interestingly, the RMD schedule starts close to 4%. At age 72, the required withdrawal rate is 3.9%, rising to 4.37% at age 75, 5.35% at age 80 and 6.76% at age 85. The upshot: There may be those who say that withdrawing 4% plus an inflation increase is too much, and yet the IRS effectively insists that retirement account investors withdraw that sort of amount—though just because the IRS insists doesn’t mean you have to spend the entire sum.

Is any retirement income guidance totally reliable? I doubt it. You’ll inevitably need to make adjustments along the way. Still, I think the 4% rule is helpful. My advice: Be more conservative than the rule suggests—and, if you’re married, that’s doubly true, because you need to make your money last for two lifetimes.

Richard Quinn blogs at QuinnsCommentary.com. Before retiring in 2010, Dick was a compensation and benefits executive. His previous articles include Banking from A to FIt Took Decades and Making Cents. Follow Dick on Twitter @QuinnsComments.

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Roboticus Aquarius
Roboticus Aquarius
4 years ago

Sensible advice.

The intent of the Trinity study was to understand the highest successful withdrawal rate that would, uplifted annually for inflation, have allowed a 50/50 portfolio (S&P500/Intermediate term Treasuries) to survive any of the 30 year rolling periods since the Great Depression (really, for as long as we’ve had decent data) without running out of money.

Anytime someone calls it a ‘rule’ and says it’s questionable, odds are high some young writer needed to get an article published.

– The 4% calculation was never a rule, at most a guideline, and nobody follows it strictly anyways (at least, I’ve never heard of anyone actually doing so.)
– Most objections to the 4% rule reflect ignorance of the conditions under which it succeeded.
– Even if 4% is no longer the maximum withdrawal percentage rate to yield 30 years of uninterrupted retirement income… it’s probably reasonably close. As you point out, one can always adjust their actual spending to compensate if the safety margin appears too small.
– There are many reasons to expect lower returns from both equities and bonds over the next 20 years or so. That was also true a decade ago. Nobody really knows. If it’s a concern for you, withdraw less to start, &/or manage as you go.
– People are living longer. 30 years might not be enough. Again, withdraw less.

Gary Welch
Gary Welch
4 years ago

One minor correction: The IRS has changed the RMD table starting in 2021 so the RMD at age 72 will be about 3.66%, 4.06% at 75, 4.95% at 80, and 6.25% at 85.

David Baese
David Baese
4 years ago

Richard,
You say ” it’s scary to retire with a pool of money to manage.” It’s even scarier to retire without a pool of money to manage.
Dave

Langston Holland
Langston Holland
4 years ago
Reply to  David Baese

The first thing I thought of was the Fiddler on the Roof. 🙂

Perchik: Money is the world’s curse.
Tevye: May the Lord smite me with it! And may I never recover!

R Quinn
R Quinn
4 years ago
Reply to  David Baese

Ain’t that the truth and 50% of those 55 + seem to be close to that position.

David Baese
David Baese
4 years ago
Reply to  R Quinn

Have you got any ideas about how those broke 55-plus people can get by?

Jack Hannam
Jack Hannam
4 years ago

I enjoy reading your posts and appreciate your wise and conservative advice to be flexible and to keep the complex medicare rules, and possible need for LTC in mind. I view the “4%” rule, along with its many variations, as providing a stable predictable income stream, which comes at a price. The “sequence of returns risk” results in correlation of asset price volatility and risk of permanent loss of capital. To mitigate the risk of portfolio depletion, one should shift proportionately more into assets with lower price volatility (more bonds, less stocks) at the price of lower growth potential. On the other hand, if I took a fixed percentage of the portfolio value every year, I must adapt to a volatile annual income stream, but it’s me, not the portfolio, paying the price. To lessen the volatility of my annual distributions, a cash cushion in the portfolio could be drawn from. The portfolio asset allocation during retirement years might more closely resemble what it had been while still working and investing. For those of us fortunate enough to enjoy good health and have adequate retirement savings, located in both IRAs and taxable accounts, we should delay drawing social security in order to maximize our benefits and regard them as a sort of “longevity insurance”. We can manage the inevitable and escalating RMD’s by drawing proportionately from IRAs and taxable accounts.

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