Posted by BRIAN PRZYSTUP & ASSOCIATES LLC

What is the 4% Retirement Rule?

What is the 4% Retirement Rule?

You might have heard about some financial rule of thumb that has circulated for years as you think about retirement and start planning for your income needs. Called as the ‘4 percent rule’ is one of them. The concept that promises to simplify your planning doesn’t always work. 

Retirement’s 4 Percent Rule

Your withdrawal rate is where the 4 percent retirement rule refers to. The withdrawal rate is the amount of money from the starting value of your portfolio of stocks and bonds in retirement that you might withdraw each year. 

For example, if you have $100,000 when you retire, during your first year of retirement, you could withdraw about four percent of that amount which is $4,000 following the 4 percent rule. 

If your portfolio allocation was 50 percent bonds and 50 percent stocks, you could then increase the amount mentioned above with inflation and you will have the probability of almost 95 percent that for at least 30 years your money would last. 

How did it start?

After the publication of Retirement Savings: Choosing a Withdrawal Rate that is Suitable, a 1998 paper, often referred to as the Trinity Study, the 4 percent rule started to circulate. Three finance professors of Trinity University authored the paper. 

The Trinity Study did not state any support of the conclusion of the 4 percent rule as ‘safe withdrawal rate’. The following are few of the paper’s compelling conclusions:

  • From allocating at least 50 percent to common stocks, most retirees would likely benefit. 
  • Retirees must accept a substantially reduced withdrawal rate from the initial portfolio if they will demand CPI-adjusted withdrawals during their retirement years. 
  • Withdrawal rates of 3 or 4 percent represent exceedingly conservative behavior for stock-dominated portfolios. 

Research Updates

In the Journal of Financial Planning, the authors of the Trinity Study published updated research in 2011. Though the conclusion did not entirely change, it stated that in order to accommodate future increases in withdrawals, clients should also plan to lower initial withdrawal rates in the 4 percent to 5 percent range if they are planning to make annual inflation adjustments to withdrawals, from portfolios of 50 percent or more large-company common stocks. 

In Wade Pfau’s study called the Retirement Researcher Blog at Trinity Study Updates, commented about the update. Wade is an academic with a specialty in retirement income and he pointed out the following points: 

  • Mutual fund fees are not incorporated in the Trinity study
  • In most other developed market countries, the 4 percent rule has not held up nearly as well as it has in the U.S.
  • Retirement lengths of up to 30 years are what the Trinity study considers. Please keep in mind that there is a good chance for at least one of the spouses living longer than 30 years if they are both retiring at age 65.

Disadvantage and Danger 

People who consider the 4 percent rule as an actual rule are usually misled. Considering this as general guidelines is the best option. The 4 percent rule will help you distinguish how much retirement income your savings can support but that depends on your desire to have your income keep up with inflation. For every $100,000 you have invested, you can likely withdraw about $4,000 to $5,000 per year. 

For your return to at least match the overall market, you should follow a specific portfolio mix with about 50 percent of your portfolio in stocks such as a diversified portfolio of stock index funds. 

Using the 4 percent rule does not account for taxes. You will pay federal and state taxes if let’s say you withdraw $4,000 from an IRA. And a total of $3,000 funds available to spend is what you will get after deducting taxes. 

Should you use this rule?

It is best to use a more precise method to decide how much money to withdraw each year in retirement although the 4 percent rule may provide a general guideline. 

Based on your other expected sources of income, expected longevity, types of investment used, expected tax rate each year, and numerous other factors, you need to craft your own plan as an upcoming retiree. It may lead to more withdrawals in some years and less in others when you will successfully build a smart retirement income plan. 

Since you are required to take withdrawals from your IRAs, once you reach the age 70 ½ the 4 percent rule will become useless, and as you grow older, you must withdraw a higher amount. 

This means that you have to pay taxes on the money even if you don’t spend the money and you don’t withdraw it from the IRA. As you get older, more than 4 percent of your remaining account value is required to be taken by formula and this formula specified these required minimum distributions. 

BRIAN PRZYSTUP & ASSOCIATES LLC
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