There is a multitude of financial advice available online. You can Google just about anything these days and find an answer that makes sense. However, even when this information comes from a credible source, more than likely, the advice you find is a simple rule of thumb. And when it comes to investing, creating a retirement plan and planning for the future, relying on rules of thumb can be tricky, because no one’s situation is ever the same.
In the financial services industry, one widely accepted rule of thumb is the 4 Percent Rule. Not only is this retirement-withdrawal plan easy to follow, but it seems to be a solid way to live off of your savings without outliving your assets. However, the 4 percent method may be better as a starting point for your retirement, rather than your be-all/end-all strategy.
Remember, financial planning is not a one-size-fits-all solution!
What is the 4 Percent Rule?
The 4 Percent Rule is a retirement strategy based on a specific withdrawal rate from your savings. As the name suggests, the strategy is to withdraw no more than 4 percent of your savings each year during retirement, and adjust for inflation going forward. The rule was first devised by financial planner Willian Bengen in 1995, and has received widespread reference in the investment world.
Here’s how it works:
Suppose you retire with $2 million in savings. In year one of your retirement, you withdraw $80,000 (4 percent of $2 million). At the end of year one, you find that your cost of living has increased 2 percent, so you increase your withdrawal an extra two percent starting in year two, as the rule states. In year two of your retirement, you would withdraw $81,600, and you follow this yearly cost of living adjustment for the rest of your retirement.
Sounds pretty simple, right?
Caveats to the 4 Percent Rule
The 4 Percent Rule can be a great guideline for your retirement plan. But it has many assumptions, and doesn’t account for the circumstances many investors face. As a Certified Financial Planner in Greenville, SC, I help many clients plan for the retirement they want, and no two situations are exactly the same. Some clients hope to spend retirement with family and grandchildren. Others have extensive travel plans. Some are business owners. Some have company stock options. Everyone’s goals are unique.
The 4 Percent Rule is Not Designed for Early Retirement
The 4 Percent Rule assumes a 30-year retirement. At Global View, we have many clients who plan to retire early, and then there are those who have to retire early, either because of a job loss stemming from the COVID-19 shutdowns or personal reasons. If you are looking to retire early, are generally healthy and expect to live well into your 90s, solely following this rule puts you at risk of running out of savings.
The 4 Percent Rule Assumes Outdated Portfolios and Returns
When the 4 Percent Rule was coined in 1995, it comprised a basic portfolio of half stocks and half bonds. Today’s portfolio models have a wider variety of investments seeking to maximize diversification and reduce unnecessary risk.
What’s more, bank interest rates were at least three times higher than they are now, meaning that investors could supplement their portfolio returns with bank interest rates, receiving an additional 4 to 8 percent from short-term CDs.
The 4 Percent Rule has Little Wiggle Room
While 4 percent of a large portfolio may seem like a relatively large dollar amount, it’s still a fixed 4 percent. In the event of extreme market events, a dramatic change in your spending or a financial emergency, that 4 percent may be too conservative for the current market. This can certainly be the case if you live in a city with a high cost of living, or if your expenses vary greatly.
Enhancing the 4 Percent Rule
The 4 Percent Rule can still be used as a good rule of thumb for your retirement. And, since future market returns are estimated to be lower than past returns, the 4 Percent Rule can be a valuable building block when constructing your full retirement strategy.
Talk with a Certified Financial Planner about how you can:
Leave a Buffer for the Unknown
For starters, remember that one of the pillars of financial freedom is being able to withstand unexpected negative events. Diversifying your portfolio, building an emergency fund or purchasing a life insurance policy are key examples of this. Market crashes, economic recessions and the new, constant threat of lockdown should be accounted for during retirement.
Therefore, a major improvement to the 4 Percent Rule is to be flexible as an investor and spender. Configure your financial plan to support temporarily exceeding the 4 percent withdrawal rate if need be, for better peace of mind. A Certified Financial Planner can help you with this.
Incorporate Your Lifetime Income
Lifetime income is usually a fixed payment you can receive for the long-term, such as Social Security and pensions, and is just one set of weapons in your financial arsenal. Since these dollar amounts are likely to be fixed, you can plan your spending accordingly and effectively.
Plan for Required Minimum Distributions (RMDs) from Your IRAs
Another thing to remember is you are required to complete a minimum distribution each year from your pre-tax retirement accounts when you turn 70-½. The amount is based on your retirement account balance(s).
So, no matter what happens financially, this is “income” that you must obtain every year. If you find that your RMD far exceeds your spending needs, talk to a Certified Financial Planner about donating your RMD to a qualified charity to potentially reduce the tax consequences.
You may be able to utilize the 4 Percent Rule for your investment and savings only, leaving your lifetime income as a surplus or extra layer of financial defense.
Spend Effectively
It may seem small, but it’s important to make sure you are maximizing how effective your spending is in retirement. What activities mean the most for you and your family? What brings you the most enjoyment? Being able to pinpoint where your spending and happiness intersect can help you make the most of your retirement years without breaking the bank.
Be sure to recalibrate your spending and priorities consistently during retirement, so your budget is always aligned with your needs, priorities and passions.
How a Certified Financial Planner Can Help
Ultimately, creating a comprehensive financial plan gives you a better chance of having a successful retirement. Preserving and maximizing your wealth requires attentiveness on every financial front. Portfolio management, estate planning, retirement spending, account maintenance – a lot goes into a well-rounded plan. Working with a fiduciary financial advisor and maintaining a long-term relationship with that person can make a huge difference. The Certified Financial Planner certification is the standard of excellence in financial planning.
With a Certified Financial Planner, an otherwise exceedingly long list of financial to-dos is covered by a dedicated professional who is devoted to implementing your full financial plan.
If you’re looking for a Certified Financial Planner in the Carolinas, contact Global View to see how we can help. Our team is held to the highest of standards and we offer an easy, no-obligation way to meet with us and see if we’re a good fit.
Harnessing the power of a dynamic strategy will make the 4 Percent Rule just one helpful piece of your active financial repertoire. Contact us and get the conversation started.
