Pros and Cons of The 4% Rule in Retirement

Financial Advisor

Retirement planning can be a complex and challenging process. You have to consider several variables, such as income, living expenses, investment returns, and inflation. Retirement can last for 20 to 30 years, sometimes more. Ensuring your retirement savings last as long as you live is essential. This is why having a withdrawal strategy can help. One popular strategy for managing retirement income is the 4% rule, which suggests that retirees should withdraw 4% of their retirement savings each year to cover their living expenses. While the 4% retirement rule has gained widespread acceptance in the retirement planning community, it is important to weigh its pros and cons before adopting it as a retirement strategy.

financial advisor can help you understand and incorporate the 4% in your retirement plan.

In this article, we will explore the benefits and cons of the 4% rule in retirement and help you make an informed decision on whether it is the right approach for your retirement planning needs.

What is the 4% rule in retirement?

Financial adviser Bill Bengen created the 4% rule in 1994. The 4% retirement rule assumes that retirees with a well-diversified investment portfolio of 50% stocks and 50% bonds can withdraw an amount equivalent to 4% of their initial retirement savings in the first year of retirement. They can then adjust that amount for inflation for every subsequent year. The rule takes into account the historical average returns of stocks, bonds, and other investments over the 50 years from 1926 to 1976.

Here’s an example to explain this better:

For example, if you have retirement savings of $1 million, you can withdraw 4% of $1 million, i.e., $40,000, in the first year of your retirement. In the second year, you can add the rate of inflation, assuming at 2%. So, you would have to increase your retirement income by 2% each year. In the first year, your retirement income would be $40,000. In the second year, it would be $40,000 x 1.02 = $40,800. You can then keep adjusting your withdrawal amount for the years to come.

It is important to note that the 4% rule is just a guideline and may not be appropriate for everyone. Over the years, a lot of financial advisors and investors have found the rule to lose its value. While it presents some benefits, there are several cons too. Let’s have a look at both.

Pros of the 4% retirement rule

The 4% rule is often considered to be a rule of thumb for retirement savingsYou can benefit from using it in the following ways:

1. It offers a structure to your withdrawals and eliminates confusion

Most people save all their lives and accumulate a sizable retirement corpus. Managing such a large sum of money can be tricky. You may feel overwhelmed at first. Seeing a large corpus may trick you into believing you have a lot of money. As a result, you may overspend in the initial years of retirement. This can lead to issues later. Retirement can last for many years, depending on when you retire and how long you live. Depleting your savings early can leave you financially unprotected in your older years. You may be forced to lower your standard of living. You may even have to compromise on essential needs like healthcare, long-term care, etc.

Not having a structured withdrawal plan can also result in withdrawing too little in the initial years of your retirement. If you fear running out of money, you may live a frugal lifestyle right after retirement in the fear of spending too much too soon. This can leave you feeling unfulfilled and stressed. It can also lead to health issues. With the 4% retirement rule, you can withdraw uniformly throughout your retirement, ensuring that you always have enough funds to match your financial needs.

2. It accounts for inflation to ensure you have disposable income to counter the rising prices

Inflation can impact the value of your money, which is why it is critical to account for it not only when you save your money but also when you withdraw it. All your major essential retirement expenses, like healthcare, groceries, home maintenance, etc., will be affected by inflation. The 4% retirement rule lets you adjust the prevailing inflation rate each year and change your withdrawal rate accordingly. As long as you use it correctly, you will have enough disposable income to cover your essential and non-essential expenses and live a comfortable life knowing you will have adequate funds for your present and future needs.

3. It is simple to use and does not require complex calculations

The 4% retirement rule is simple and does not require lengthy calculations. It requires you to use one figure to determine your withdrawal for the first year. After the first year, you can add the inflation rate to the equation and compute your withdrawal rate. The inflation rates are shared by the U.S. Bureau of Labor Statistics. All retirees, irrespective of their education, profession, or age, can comfortably use the rule. You can also find many retirement calculators online, or consider contacting a financial advisor if you need help calculating your distribution for the year.

Cons of the 4% retirement rule

The 4% retirement rule can present several cons. Some of these have been discussed below:

1. The rule can be restrictive and does not account for variables

The 4% rule is considered to be rigid by many financial experts as it remains fixed irrespective of external factors. For instance, the rule only considers the inflation rate and not how the market performs. The value of your investment portfolio can be impacted by other things, such as market downturns. Your spending habits, financial liabilities, and responsibilities may also affect your withdrawal rate. You may spend more in some years and less in others. For instance, in the initial few years of retirement, you may still support your kids and pay for their education, travel, and other expenses. These will potentially be eliminated as your children get jobs and are settled in their careers. However, the 4% rule assumes that your expenses will be identical every year of retirement.

The inflation rate may also not be the same every year. The year 2022 saw an exceptionally high inflation rate, with consumer prices up 9.1%. The inflation rate for 2019 was only 1.81% and 2.44% in the year before that. Changing rates can deplete your savings sooner than anticipated.

2. The rule assumes your retirement will last 30 years, which may not always be the case

One of the significant drawbacks of the 4% rule is that it is constructed on the assumption that an average retirement lasts 30 years. While this may have been common in the 90s when the rule was introduced, things have drastically changed today. The retirement age can differ for different people, with some retiring in their 40s and 50s and others continuing to work well into their 70s. The 4% retirement rule does not incorporate these factors.

3. The rule is based on a specific portfolio composition that may not be the same for everyone

When the rule was founded, the assumption was based on a hypothetical investment portfolio with an asset allocation of 50% in stocks and 50% in bonds. Your portfolio may or may not be the same at retirement and the years after. Ideally, financial advisors recommend adjusting your asset allocation based on your reducing risk appetite with age. The rule is likely to falter, assuming you have an asset allocation of 40% in stocks and 60% in bonds, vice versa, or any other permutation and combination.

4. The rule takes into account historical market returns from 1926 to 1976

Bill Bengen studied the historical market returns of 50 years from 1926 to 1976 and devised the 4% rule based on the returns generated back then. Things have changed now. Moreover, past performance is not always indicative of future performance. Your investment portfolio may or may not generate similar returns. Looking at the recent past and approaching future statistics, you will notice that markets suffered significantly in 2020 due to COVID-19. The economy is now preparing for a recession. These factors and more will likely affect your returns.

5. The rule does not include taxes, penalties, and other investment charges

Your retirement savings can be subjected to tax, penalties, and other charges. The rule ignores these expenses and only considers inflation in its calculation. Taxes are going to be one of the primary expenses in retirement. They are also expected to change over time as per prevailing tax laws. The taxability of your investments can differ based on their type. Capital gains and income from Traditional and Roth retirement accounts like the 401k and the Individual Retirement Account (IRA) will all be differently taxed. You may also pay penalties on some withdrawals. For instance, early nonqualified withdrawals from a 401k or IRA before the age of 59 years can result in a 10% penalty. Traditional retirement accounts also have mandatory Required Minimum Distributions (RMDs) from the age of 73. If you fail to withdraw an RMD on time or withdraw the wrong amount, the amount not withdrawn is taxed at 50%.

In addition, you may incur expenses like account maintenance fees, broker charges, etc. These will ultimately be deducted from your 4% withdrawal, leaving you with fewer funds to cover your primary expenses.

6. The rule does not take into account the possibility that retirees may live longer than expected

Life expectancy has changed over the years. With advancements in medicine and technology, people may live longer in the years to come. Longevity risk is one of the primary concerns for retirees today, and it is uncertain how long your money will last using the 4% rule beyond the 30-year time frame. The rule may lead to a depletion of retirement savings sooner than anticipated and cause financial distress in old age.

How can you ensure a financially comfortable retirement and an optimal withdrawal rate?

Your actual retirement income needs may vary depending on your lifestyle, expenses, and other factors. It is advised to start by evaluating these factors. Draft a withdrawal plan according to when you plan to retire from your job/business, how long you can keep working part-time after retirement, your health, your family’s history of illnesses, etc. Also, take into account your retirement savings at the time of retirement, whether or not you can depend on your spouse financially in retirement, financial liabilities concerning your children, and other similar aspects.

It can help you to use financial tools like annuity plans that offer guaranteed income in retirement along with steady growth through low-risk returns. Annuities can be ideal for retirees and are just as simple to understand and use as the 4% retirement rule.

Keeping a diversified portfolio with the right concentration of different asset classes suited to your risk appetite and retirement goals may be recommended. This will ensure sufficient savings and protect you from concerns like taxes, inflation, and other factors that can negatively impact you financially.

Depending on your financial situation, the 4% rule may or may not suit you. It is always a good idea to consult a financial advisor to determine the best retirement strategy for your needs.

To conclude

The 4% retirement rule is a popular retirement income strategy that can provide you with a steady stream of income throughout your retirement years. However, it is essential to consider the potential drawbacks of this approach and to assess whether it is the right strategy for your retirement planning needs. As always, it is recommended to consult with a financial advisor before making any significant retirement planning decisions. Use the free advisor match service to connect with a financial advisor in your area who can help you determine whether or not the 4% rule is ideal for you. All you have to do is answer a few simple questions based on your financial needs, and the match tool will help connect you with 1-3 advisors that are best suited to meet your financial requirements.

For additional information on suitable retirement saving strategies for your financial needs, visit Dash Investments or email me directly at dash@dashinvestments.com.