Continuing my Planning for Retirement Series based on my How to Recreate Your Paycheck in Retirement class.
Last week’s post covered why you need to invest for retirement: it’s likely to be longer than expected due to increased life expectancies and people often retiring sooner than planned, inflation erodes purchasing power by half during retirement, and we need portfolio growth on top of our savings to fund a long retirement.
Here we’re looking at how much you need to save for retirement. What’s your number so to speak? And since that’ll be different for everyone based on lifestyle and income sources, it evolves into what a safe target portfolio withdrawal rate should be in retirement.
The 4% Rule
The 4% rule is ubiquitous in financial planning. A young financial advisor named William Bengen wanted to figure out the retirement math for his older clients, and he shared his findings in Determining Withdrawal Rates Using Historical Data in a 1994 Journal of Financial Planning issue.
Bengen reviewed historical returns for a 60% stock/40% bond portfolio and inflation history and concluded that 4% of your initial portfolio value is a safe retirement withdrawal rate you can then increase annually for inflation.
His conclusion accounted for severe market downturns and above average inflation, and he defined safe as lasting at least 30 years.
You’re not withdrawing 4% from your portfolio each year. You’re withdrawing 4% that first year and increasing the next year’s withdrawal by inflation. You’ll likely have other income coming in that you can spend, like Social Security. You’ll also have to pay taxes, so it’s not all going to spending.
What’s now known as the has its critics, but based on the numbers and my experience, I think it’s an excellent starting point.
Substantiating the Safe Retirement Withdrawal Rate
This chart shows the likelihood of a financially successful 35 year retirement at different withdrawal rates and asset allocations. 4% has high likelihood of success across the board (except for cash) and wouldn’t cause underspending in retirement.
That last point is important. 4% rule critics believe a more dynamic spending strategy based on the market environment and spending flexibility allow for a higher withdrawal rate.
That’s true. However, the 4% rule is a good pre-retirement guidepost. Whether you have the opportunity to improve upon it in your own retirement will come down to the investment environment and trade-offs you’re willing to make.
I’ve also seen the 4% withdrawal rate work well for the retirees I’ve helped over the years. It’s allowed them to maintain purchasing power, grow their portfolios in good years, and avoid big steps back in bad years. And to the flexibility point above, because the portfolios are maintaining their purchasing power, clients have had the opportunity to gift to family and make the occasional unbudgeted expenditures and stay on track.
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Related Reads
Investing for Retirement (Part One in the Series)
Building Your Retirement Budget (Part Three in the Series)
