What is the 4 Percent Rule and Why You Should Avoid It Even if you aren't basking in your golden years just yet, just the thought of retirement can cause you to wake up in a cold sweat. Approximately two-thirds of Americans...

Even if you aren't basking in your golden years just yet, just the thought of retirement can cause you to wake up in a cold sweat. Approximately two-thirds of Americans (67%) have said the country faces a retirement dilemma. In addition, 56 percent are worried they will not be able to afford a secure retirement.

More specifically, some of the most common concerns regarding retirement include;

• Carrying too much debt. In retirement, more than one-quarter of Americans are concerned about having too much debt.
• Being able to pay living expenses. Nearly 4 in 10 Americans (39%) are concerned about paying for essential expenses.
• Having the means to cover medical bills. According to SimplyWise, nearly half (47%) of Americans worry about paying medical bills when they retire.
• Outliving your savings. Half of all Americans are worried that their savings will run out while still alive.
• Social security running out. A majority of Americans (55%) worry that Social Security will not be there for them when they need it.

How can these concerns be addressed so that you can sleep more soundly at night? Well, there isn't one right answer. However, among financial planners, the conventional wisdom would be to rely on a 4% withdrawal rate.

What is the 4% Rule?

As the name implies, this rule of thumb states that the best way to ensure that you won't run out of retirement funds is to make annual withdraws of 4 percent.

"It's relatively simple," state Rob Williams and Chris Kawashima for Charles Schwab. "You add up all of your investments, and withdraw 4% of that total during your first year of retirement."

"In subsequent years, you adjust the dollar amount you withdraw to account for inflation," they add. "By following this formula, you should have a very high probability of not outliving your money during a 30-year retirement according to the rule."

Take, for example, a portfolio worth $1 million at retirement. Your first withdrawal would be $40,000. Assuming the cost of living increases by 2% that year, you will give yourself a 2% raise the following year, withdrawing $40,800, and so on for the next 30 years, Williams and Kawashima explain.

In short, according to the 4% rule, "you withdraw the same amount from your portfolio every year adjusted for inflation."

Origins of the 4% Rule

This rule was derived from a study by William Bengen, an investment management specialist, that was published in 1994. The study involved Bengen investigating sustainably withdrawing from retirement portfolios. Specifically, he examined the withdrawal rates from 1926 through 1963 for rolling retirement periods of 30 years.

"Based on a historical reconstruction of retirees' portfolios since 1926 (with respect to asset class returns as well as inflation), these papers recommended a 4% withdrawal rate for the first year, followed by cost-of-living adjustments every succeeding year," he wrote. "This applied to tax-deferred portfolios seeking a minimum 30-year "longevity.'"

In later years, Bengen increased his recommendation to a first-year withdrawal rate of 4.5% by using additional asset classes. Nevertheless, the conclusions of the original study have endured, and have come to be known as "The 4% Rule."

Since then, the 4% rule has become a common rule of thumb in retirement planning. And, it's easy to see why. Mainly because it's simple to follow. Moreover, as long as you have a steady and predictable retirement income, you know how much you can withdrawal. In turn, this prevents you from running out of money.

Why You Should Tread Lightly With the 4% Rule

The 4% rule probably isn't the best idea if you want to be 100% certain you will never run out of cash. That's not to downplay the work that Bengen conducted. I'm sure that it was a massive and tedious undertaking. But, it's antiquated.

Moreover, the 4% rule doesn't account for changing market conditions. As an example, it wouldn't be financially sound to increase your withdrawal amounts during a recession. In fact, you may actually reduce them. On the other hand, when the market is doing well, you might be in the position to withdraw more than 4%.

Another problem with the 4% rule? It's based on a 30-year time frame. Well, that can be a decent starting point, if you can't retire until you're 70, you should adjust your horizon as you may not live to 100 years old. And, there's also the possibility that your portfolio will even last for a 30-year period.

Additionally, the 4% rule doesn't account for;

Medical expenses.

As we get older, medical expenses become more common, especially in the golden years of retirement, but it's impossible to predict exactly what you'll be charged for, states Jessica Blankenship for Bankrate. Furthermore, some medical procedures are much more costly than others. Life expectancy is another important factor that impacts the 4% rule. It goes without saying that as you age, your savings will need to last longer.

Personal tax rate.

In terms of your personal tax rate, it depends on a number of factors, including the type of investment accounts you have, the size of those accounts, and how much income you have other deductions and credits, and what state you live in, adds Blankenship.

Asset allocation.

For a hypothetical portfolio invested 50 percent in stocks and 50 percent in bonds, the rule applies. During retirement, you may make changes to your investment portfolio over time. "We generally suggest that you diversify your portfolio across a wide range of asset classes and types of stocks and bonds, and that you reduce your exposure to stocks as you transition through retirement," states Williams and Kawashima.

Changes in spending patterns.

"The 4% rule assumes you increase your spending every year by the rate of inflation—not on how your portfolio performed—which can be a challenge for some investors," Williams and Kawashima. Furthermore, it assumes that you won't have years where you spend more or less than inflation increases.

In reality, the average retiree does not live this way. Over the course of your retirement, your expenses are likely to change from year to year. For instance, recent retirees may spend more money on travel and pursuing new hobbies. After a couple of years, though, spending decreases. But, it may increase as they get older due to healthcare costs.

Alternatives to the 4% Rule

To be fair, the 4% rule can be used as a starting point. And, depending on your investment portfolio and retirement goals, you can use it as a measuring stick. At the same time, you may want to explore the following alternatives as well;

The $1,000-a-month rule of thumb.

One possible strategy for sustainable retirement withdrawals is the $1,000-a-month rule. According to this rule, you would start with $240,000 a year in retirement savings. You would then withdraw $12,000 annually, or $1,000 per month, for 20 years. The $1,000 monthly withdrawals would need to be complemented by low costs of living or an additional source of income. And, it doesn't compensate for inflation or annual cost-of-living increases.

The multiply by 25 rule.

While not exactly a retirement withdrawal rule of thumb, it's kind of a prerequisite for the 4% Rule. You can withdraw 4% of the amount saved every year if you save 25 times your desired annual retirement salary and it will last you for 30 years if you save the 25X rule.

Get a little help from the IRS.

The IRS''s Annual Percentage Withdrawal Table may also serve as a good rule of thumb for determining the appropriate retirement withdrawal rate – irrespective of the age of the account, according to the Center for Retirement Research at Boston College.

In order to avoid hefty tax penalties, starting at age 72, you must take out a certain percentage of your 401k and IRA savings every year. The IRS publishes the required minimum distribution tables that show how much you must withdraw. Using life expectancy tables, the IRS calculates your withdrawal amount. By dividing your balance by your life expectancy factor you can obtain your net worth.

In short, with the RMD retirement withdrawal strategy, you would apply the IRS RMD formula to any retirement account at any age.

Annuities.

To address lower withdrawal rates, fixed index annuities (FIAs) may be another potential solution, states Shawn "The Annuity Expert" Plummer. When compared to pure withdrawal rate strategies, FIAs and annuities, in general, may provide a greater guarantee of income.

FIAs are designed to provide lifetime income to retirees and may include income benefit riders, which can either be built-in or additional fees.

Frequently Asked Questions (FAQs)

Does the 4% rule still work?

Aside from being outdated, the 4% rule fails to consider changing market conditions. Additionally, the rule was established at a time when bond interest rates were very high.

In fact, Morningstar's The State of Retirement Income: Safe Withdrawal Rates, estimates "that the standard rule of thumb should be lowered to 3.3% from 4.0%, assuming a balanced portfolio, fixed real withdrawals over a 30-year time horizon, and a 90% probability of success (that is, a high likelihood of not running out of funds over the time horizon)."

If I withdraw 4% per year, how long will my retirement last?

In the same way that you cannot perfectly predict how the market and inflation trends will behave, you cannot perfectly predict how long your retirement funds will last. Although the 4% rule is a good starting point, it is advisable to consult a financial planner before implementing it.

In retirement planning, how should inflation be taken into account?

As you begin investing in retirement, inflation should always be taken into account as you plan your annual withdrawals. As inflation tends to average between 2% and 3% annually, the total you will need when you retire should incorporate this increase. And, the number of withdrawals you take each year in retirement will increase as inflation increases.

What is a 4% rule calculator?

The 4% rule calculator allows you to calculate your retirement income as per the 4% rule. You can use it to determine how much you need to save to withdraw a specified amount each year.

Can the 4% rule apply to early retirement?

Short answer? No.

Since the 4% rule is based on a traditional 30-year retirement, it's designed for those retiring at 65 or older. So, if you are retiring at an earlier age, this rule wouldn't be effective.

The post What is the 4 Percent Rule and Why You Should Avoid It appeared first on Due.