When planning for retirement, most people are focused on how much they need to save. They tend to spend less time thinking about how they’ll make their nest egg last once they stop working.
Here are some important things to know about retirement withdrawal rates to make your savings last.
The 4% Rule
To avoid the danger of draining your savings, you need a plan. That means knowing how much you can withdraw from your portfolio every year. This is called your retirement withdrawal rate. There’s actually a pretty simple rule of thumb you can use to estimate how much you can safely take from your savings. It’s called the 4% rule.
The 4% rule says that you can withdraw roughly 4% of your portfolio every year and have enough money to last for a 30-year retirement (assuming you are invested in a 60/40 mix of large-cap stocks and intermediate-term government bonds). For example, if you had a total retirement portfolio of $1 million when you retire at 65, you could withdraw about $40,000 every year and have enough money to last until you turned 95.
Combined with Social Security and pension income, your 4% withdrawal rate could provide you with a respectable, though not necessarily lavish, income. If you wanted to enjoy an annual income in the six figures in retirement, you’d have to save quite a bit more.
Does the 4% Rule Matter?
There’s a lot to be said for the 4% rule, but it’s not the be-all and end-all of retirement planning. In fact, some retirement experts have said that today’s retirees should forget about the 4% rule, or at least apply it with caution. Low interest rates are one reason, because they mean that retirees aren’t earning as much on their relatively safe investments (like government bonds) as they would if they’d retired a couple of decades ago (when the 4% rule was first proposed).
Another problem is what is called sequence of returns risk. Basically, the 4% rule assumes you earn relatively stable average returns throughout your retirement. Unfortunately, that’s not how the real world works. Returns fluctuate from year to year. If you hit a bad patch in the early years of retirement, the value of your portfolio may fall, and you may never be able to make up the loss.
Finally, there is something called the sequence of consumption risk. The 4% guideline assumes your spending is relatively steady throughout retirement. But recent studies indicate that’s not the case for most retirees. You’re likely to spend more money in the early years of retirement (when you’re still relatively young and active), less in the middle years of retirement, and more in the final years of your life (when healthcare costs often pile up). Spend too much in the early years, and you could find yourself running out of money in later years.
A Guideline, Not a Rule
Rather than treating a 4% retirement withdrawal rate as a hard and- fast rule, it’s better to think of it as a starting point. Thinking about living on 4% of your portfolio every year is a good way to get a rough idea of how far your retirement dollars will go. But by itself, it won’t be enough. To really determine how much, you can withdraw from your savings every year, please call to discuss this in more detail.