Top of Mind


The 4% Withdrawal Rate: Is it Still the Rule of Thumb?

As baby boomers continue to age and more and more retirement plan participants approach retirement, plan sponsors need to move distribution planning from an afterthought to “Top of Mind” (yes, I know - don’t quit my day job!).

It used to be a given that distribution planning for retirement was fairly straightforward.  In the early 1990s, a retirement planner by the name of Bill Bengen devised the 4% Rule:  If an individual has a well-diversified retirement portfolio, he/she can safely withdraw 4% each year (adjusted for inflation) and not outlive his/her money, assuming a retirement of 30 years.  Based on this rule, distribution planning is simple:  determine expenses in retirement and ensure that they do not exceed any Social Security benefit (and defined pension benefit, if applicable) plus 4% of an individual’s remaining retirement assets.

The beauty of the formula is that the 4% only needed to be calculated once on the opening balance.  For example, if an individual has $1 million, he/she could withdraw $40,000 in year one.  In year two, even if your portfolio dropped in value, he/she could still withdraw $40,000, adjusted only for inflation (i.e., if inflation was 5%, he/she could withdraw $40,000 x 1.05, or $42,000). It is quite a simple formula.

But things have become complicated in the intervening years, which may mean that the 4% Rule is not as much of a “rule” as it once was. Some of these complexities include:

  • The bond market has essentially tanked since the 1990s, lowering the return of the well-diversified portfolio that Mr. Bengen envisioned (which was essentially a split between stock and bond investments).
  • People are living much longer, which stretches the boundaries of the 30-year retirement scenario.
  • With the rise in retiree medical expenses, costs have gone from level and easily predictable to - well, all over the place.  For example, year-one retiree medical costs could be 3% while year-two costs could be 10% if an unpredictable medical event occurred.

While distribution planning has become a lot more complicated over the years, there are some tips to help plan sponsors and participants:

  • Smash Savings Goals— For example, if $40,000 of retirement income is needed outside of pension and/or social security, an individual would need to save $1 million (or 25 times $40,000) to be safe under the 4% rule. However, if that individual were to save $1.5 million, he/she will likely be safe, even if the 4% rule were to fail.  So, don’t just aim to meet savings goals – smash them!
  • Don’t Wait Until Retirement to Start Managing Expenses — If an individual is not tracking expenses and budgeting now, it is going to be far more difficult to do so in retirement. And tracking/budgeting now can also have the effect of lowering current expenses, which can result in more retirement savings – and thus, more income in retirement!

Do you think that the 4% rule is still a good rule of thumb?  Feel free to share your thoughts with me on Twitter or at info@cammackretirement.com.  

Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.

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