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Why the 4% retirement rule no longer works

When planning retirement, many people are looking for simple rules to follow. There are many there – one of the most common is the 4% withdrawal rule. It says that you can comfortably withdraw 4% of your savings in the first retirement year and then adjust the amount of inflation for each subsequent year, thus avoiding running out of money for at least 30 years.

That sounds good in theory, and it may even work for some in practice. But if you blindly follow this formula, you may still end up running out of money or end-of-life financial profits that you could spend on things you like.

  Senior man with hand on mind chin

Image source: Getty Images.

The problems with the 4% rule

As with many of these so-called pension rules, 4% have for simplicity, but are not flexible enough for a wide range of scenarios. It assumes that your investment portfolio contains about 60% shares and 40% bonds, but your assets can be distributed differently. Investing more in bonds can lead to lower investment growth, because bonds typically do not see the returns that equities make, and when the 4% rule was developed, the bond yield was much higher than today. Following the 4% rule in this scenario may cause you to withdraw too much.

The rule also does not account for changing market conditions. In a recession, it is probably not wise to increase your withdrawal rates; you may want to reduce them a little. But when the markets are doing well, you may be able to withdraw more than 4% comfortably.

A third question is that it does not account for changes in consumption and activity levels during your later years. Most retirees are more active in the early part of retirement. They often spend more time on hobbies or travel, and the expenses are often higher than when they start to slow down and spend more time closer to home.

But the 4% rule is not dynamic enough to account for these lifestyle changes. It limits you to a preset amount, which may be too small in the first few years and too much in recent years. As a result, you end your life with a lot of money left over, and you failed to enjoy your early retirement as much as you wanted.

How to determine how much you can spend annually in retirement

There are other retirement withdrawal strategies that are a bit more dynamic than the 4% rule. The Center for Retirement Research at Boston College proposed a system where you base your annual retirement deductions from the IRS minimum distribution requirements (RMD). RMDs are the amounts you must start taking from all retirement accounts except the Roth IRAs when you are 70 1[ads1]/2, unless you are still working and do not own more than 5% of the company you work for. You divide your account balance by the distribution period next to your age in this table to determine how much you need to withdraw each year.

The Center for Retirement Research used this as its cut-off point and calculated annual withdrawal amounts as a percentage of your total account balance beginning at age 65 – claiming that you can safely withdraw 3.13% of your retirement savings – for 100 years, when you can withdraw 15.67%.

This formula has some of the same shortcomings as the 4% rule. Changing market conditions can affect what you can safely charge, and you are limited to smaller amounts when you are younger and may want to spend more. But you can make up for this by using earned interest and dividends in addition to the recommended percentages.

An even better approach is to completely ignore the cookie-cutter strategies. Talk to a financial advisor about your retirement plans and how they will affect your spending habits. An advisor will help you decide how much you need to save and how much you can comfortably spend each year to avoid running out of money too soon.

Make sure you choose a fee-only financial advisor. Those who earn commissions when buying certain investments may make recommendations based on the bottom line rather than your best. Always request a copy of an adviser fee plan so that you understand what you are signing up for.

The 4% rule can be a useful starting point for deciding how much to spend annually in retirement, but be aware of the limitations. Your needs and goals in your later years are dynamic, and you need a withdrawal plan as well.

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