Exploring The 4% Safe Withdrawal Rate
One of the greatest fears in retirement is running out of money. How much money do you need to save to live comfortably? Will I have enough to cover my expenses?
These are questions that everyone faces as they approach retirement. Fortunately, there’s a retirement strategy that helps you determine how much you can safely withdraw without running out of money. However, one study performed in 1994, analyzed these questions and established guidelines to help prevent folks from running out of money in retirement.
According to the findings, retirees can “safely” withdraw 4% of their starting balance each year for 30 years, as long as their money is invested in a mix of stocks and bonds during their retirement. Since the study was performed, there has been much debate surrounding what is now dubbed, the 4% rule.
In this article, we’ll explore the 4% safe withdrawal rate, the key factors for you to consider, and how it can help you with planning your income stream in retirement.
HOW DOES THE 4% RULE WORK?
Key Components Of The 4% Safe Withdrawal Rate:
- The 4% rule states that you have a high probability of not outliving your retirement savings if you withdraw no more than 4% of your starting balance each year. Although the rule does not guarantee you won’t run out of money, it demonstrates that regardless of market upswings and downturns over a 30-year period, you are nearly certain not to run out of money in retirement.
- The 4% rule adjusts for inflation. Inflation measures price increases in the economy from one year to the next. Under the rule, if inflation rises, you can withdraw more money from your retirement to match the inflation rate of that year. This is good news since the price of living can increase over time. And by adhering to the safe withdrawal rate, you’re able to withdraw more money as inflation rises without depleting your savings. For example, if you’re currently withdrawing $20,000 per year, and inflation rises by 2%, you can safely withdraw 2% more or $20,400 for that year.
- The 4% rule assumes you’ll keep your money in stocks and bonds no matter what happens to the market. Consistently investing each year is an important component in determining the safe withdrawal rate of 4%. The rule only works if you remain in the market for the 30-year period. In other words, if the market corrects by 30%, your retirement money is to stay in the market. By keeping your funds invested in the market during bad times, you benefit when the market ultimately bounces back from those corrections.
Let’s look at an example of the 4% rule:
Bill wants to know how much he can spend safely without running out of money in retirement.
First, we have to determine Bill’s level of savings. Bill has $500,000 in an IRA and $500,000 in a regular savings account, or a taxable account.
Second, we need to know if Bill has any sources of income while in retirement. Bill doesn’t have a pension, but he will collect $16,000 per year from Social Security.
Using the 4% rule, Bill can safely withdraw $40,000 per year and will not deplete his total savings of $1,000,000 in 30 years. We arrived at the $40,000 number by multiplying $1,000,000 * 04 (or 4%).
It’s important to note that regardless of market corrections, Bill will be able to withdraw $40,000 each year. In our above example, if the stock market drops 20% in year five of Bill’s retirement, Bill will continue to withdraw the same amount of $40,000 each year. The safe withdrawal rate takes into account for market corrections and allows Bill to maintain a consistent income stream of $40,000 each year in retirement plus any increase due to the inflation rate.
Combined with Social Security, Bill will have a high probability of $56,000 in yearly income ($40,000 + $16,000) to spend in retirement for 30 years.
Factors For You To Consider In Determining Your Safe Withdrawal Rate:
What age you retire will impact whether you have enough money saved for retirement. You might choose to retire early, at 62 years years old, or perhaps you decide to wait until your 67. You might also opt to collect Social Security early, or you might opt to defer your benefits until later years. These age-related decisions will have an impact on how long your savings lasts in retirement. The safe withdrawal rate helps you with these decisions because you can determine your yearly income stream that’s available to you given your savings balance and the age when you retire.
The timing of financial market corrections can play a significant role in determining whether or not you outlive your savings. Let’s say; you did everything right, you saved money each year while working. You diversified your investments, and yet, a few years into retirement, the financial markets go into a tailspin, and you watch your savings dwindle.
For those who retired at the onset of the financial crisis in 2009, this was the reality. Following the crisis, the markets fell 30% at one point wiping out years of hard-earned savings. For those who were retiring during this period, they saw an immediate reduction in their savings and put them at a distinct disadvantage to those who retired in earlier periods. As a result, the year in which you retire and how long afterward a market correction ensues plays a major role in whether you’ll have enough saved for your retirement.
Under the 4% rule, you can stay the course through turbulent times and still have enough income throughout retirement. The safe withdrawal rate of 4% is just that; it’s the safest amount you can withdraw without running out of money. The withdrawal rate factors in market corrections and bad times.
Today’s interest rates are lower than in 1994 when the safe withdrawal rate was created. In 1994, you could deposit money in a one-year certificate of deposit at your local bank and receive 6% interest on your money. Unfortunately, today’s rates earned from savings accounts and CDs are a fraction of what they once were. Interest rates were much higher when the study was performed as compared to today’s low rate and less stable environment.
However, today’s interest rate instability does not necessarily mean the 4% rule doesn’t apply anymore. Instead, diversification plays an increasingly important role in determining your rate of return on your money and how long your savings will ultimately last. Whether you invest in a mix of bonds, dividend-paying stocks or other investments, diversification is a critical factor in offsetting today’s low interest rates. The safe withdrawal rate encourages diversification through a healthy mix of stocks and bonds that helps offset any market periods of low interest rates.
The 4% safe withdrawal might be too conservative. You might find that each year, you have enough income to cover your expenses in retirement and as the years go on, you find you haven’t spent enough.
The concept of having too much saved in retirement is contrary to what we’re taught while working. We’re taught to save, save and save even more. However, the safe withdrawal rate includes principal withdrawals of your starting balance, but your portfolio will likely have market gains and dividends added to your balance over the 30-year period. Those market gains are not figured into your yearly withdrawal amount. As a result, you may find you can withdraw more money as the years go on if the financial markets perform well for a period of time.
Also, your expenses are likely to be lower in retirement. Whether your home mortgage is paid off or whether you’ve downsized to a smaller place, you’re likely to have lower monthly expenses in retirement than while working. And when you combine lower living costs with your income from Social Security, gains and dividends from the financial markets, you might find in your later years, that the safe withdrawal rate wound up being too conservative. As a result, you might find you have more money to withdraw than you originally had planned.
The 4% safe withdrawal rate helps you determine the amount of annual income that you can spend and not run out of money in retirement. Of course, the 4% rule isn’t a substitute for an actual income plan but rather a helpful tool in aiding you in developing that plan.
The amount of annual income depends on many factors including how much you have saved and at what age you begin retirement. However, the 4% safe withdrawal rate helps you determine the maximum amount you can safely withdraw each year, despite market corrections, and still have enough to live on throughout your retirement.