The 4% withdrawal rule is well known among financial planners and people planning their retirement. It was developed by William Bengen in 1994. The rule says that if people withdraw 4% in the first year of retirement, and adjust that amount for inflation every year after that, the money would last about 30 years.
Another way of looking at the 4% rule is that you need 25 times your annual expenses to retire. We generally ignore other sources of income such as social security when we work with this rule.
The great thing about the 4% rule is that it works under most market conditions. It is also easy to understand and implement.
But there a few problems with the 4% rule, and it may not work under certain conditions.
The 4% rule assumes that people will invest 60-70% of their portfolio in stocks, and the rest allocated to bonds. In retirement, many people may not have the risk tolerance to put 60-70% of their portfolio in stocks. They would rather prefer more stable investments. But a very conservative portfolio will not allow you to withdraw 4% a year for 30 years.
Sequence of Returns Risk
Assume you had just retired, and the stock market crashes. What happens to your retirement plan? Can you still withdraw 4% per year? This actually happened to people who retired in 2007 and 2008. The S&P 500 lost 37% in 2008.
If the market crashes in the first or second year of retirement, and you continue to withdraw 4% every year, you are at risk of running out of money earlier than someone who didn’t face a market crash early in retirement.
Even after major market setbacks, stock market returns have typically returned to historical levels and you will probably be fine taking out 4%. You need to understand that there is some risk involved when you withdraw 4% per year when the returns in the early years are negative.
Low-Interest Rate Environment
In the 1970s and 1980s, inflation was in double digits and so was the yield on bonds. Retirement planning was much easier when people could plan on getting double-digit returns on bonds. People could reduce their investment in stocks, and put more money in bonds in retirement.
But since the 2007 financial crisis, the interest rate has been very low. This has led people to invest a higher percentage of their portfolio in stocks to generate returns. Since the stock market is more volatile than the bond market, retirees are exposed to more portfolio volatility in retirement years.
Not Everyone Needs 30 years of Retirement Income
People are working longer than ever. It’s not uncommon to see people working in their mid-70s. In that case, you can safely withdraw more than 4%. While some of you will play it safe, some others may want to withdraw more than 4% to live a more luxurious lifestyle in later years.
If you retire early, the 4% rule may not work well for you. You will likely have more than 30 years in retirement. You will need other forms of income and need to consider a withdrawal rate lower than 4%.
With all these challenges, how you plan your withdrawals in retirement. Here are a few strategies that can work well.
Be Flexible With Your Withdrawals
Being flexible with withdrawals goes a long way in ensuring that you don’t outlive your assets. When the market is in a downturn, reduce your withdrawals. This allows more of your money to compound over the years.
Work longer. Get A Side Hustle
Consider a part-time job or side hustle that generates income. Many retirees actually enjoy working on part-time jobs because it keeps them active rather than staying at home all day. Do not rely on just your assets for income in your retirement years.
Reduce the Cost of Living
Your cost of living in retirement should be lower in most cases. Look at your expenses and see if there are opportunities to reduce expenses further.
4% withdrawal rule is a good rule of thumb and works most of the time. But there are risks associated with withdrawing 4% every year. Understand the risks, and be flexible with your withdrawals. Working longer before you retire and working on a side hustle in retirement will give you a safety net and ensure that you will not run out of money.