Table of Contents
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.
How Does the 4% Retirement Withdrawal Rule Work?
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.
How Was the 4% Rule Calculated?
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.
How Are Retirement Withdrawals Adjusted Over Time?
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 4% rule has its critics, but based on the numbers and my experience, I think it’s an excellent starting point.
What Does the Research Say About the 4% Rule?
This chart shows the likelihood of a financially successful 35-year retirement at different withdrawal rates and asset allocations. 4% has a 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 allows 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.
The 4% rule can provide a useful retirement planning guidepost, but your income sources, taxes, investment allocation, retirement timeline, and spending flexibility all affect how much you can reasonably withdraw.
A withdrawal rate should not be evaluated separately from the investments supporting it. A retirement portfolio checkup can help you determine whether your stock and bond allocation is aligned with the withdrawals you expect to take.
Free Retirement Class
How Will Your Portfolio Replace Your Paycheck?
A withdrawal rate is only one part of creating reliable retirement income. If you are within 5 to 10 years of retirement, Sammy’s free class explains how investments, taxes, Social Security, income, and risk can work together.
Watch the Free Retirement Class →It’s educational and not personalized investment advice.
Frequently Asked Questions About Safe Retirement Withdrawal Rates
Is 4% still considered a safe retirement withdrawal rate?
The 4% rule remains a useful starting point for retirement planning, but it is not a guarantee. The appropriate withdrawal rate depends on factors such as retirement length, investment allocation, inflation, taxes, other income sources, and how flexible you can be with spending.
Does the 4% rule mean withdrawing 4% every year?
No. Under the traditional rule, you withdraw 4% of the portfolio’s initial value during the first year of retirement. In later years, the dollar amount is generally adjusted for inflation rather than recalculated as 4% of the portfolio’s current value.
How much income can a $1 million portfolio provide using the 4% rule?
A 4% initial withdrawal from a $1 million portfolio would equal $40,000 during the first year. That amount does not include Social Security, pensions, taxes, or other income and expenses that may affect the amount available for retirement spending.
Can someone withdraw more than 4% in retirement?
Some retirees may be able to begin with a higher withdrawal rate, particularly when they have flexible spending, reliable outside income, a shorter planning horizon, or favorable investment returns. Higher withdrawals can also increase the chance of depleting the portfolio sooner.
How does inflation affect retirement withdrawals?
Inflation reduces the purchasing power of retirement income over time. The traditional 4% framework accounts for this by increasing the initial dollar withdrawal with inflation each year, but sustained high inflation may still place additional pressure on a retirement portfolio.
Does Social Security change the withdrawal rate someone needs?
Yes. Social Security, pensions, rental income, and other dependable income sources can reduce the amount that must be withdrawn from investments. The portfolio withdrawal rate should be considered alongside the retiree’s full income plan rather than evaluated in isolation.
What happens if the market falls soon after retirement?
Losses early in retirement can be especially difficult because withdrawals may require selling investments after they decline. This is known as sequence-of-returns risk. Asset allocation, spending flexibility, bonds, and cash reserves may help manage this risk.
_______________________________________________________________________________________
Continue Your Retirement Planning
- Investing for Retirement — Part One in the Series
- Building Your Retirement Budget — Part Three in the Series
- Is It Time for a Retirement Portfolio Checkup?
- Explore More Retirement Planning Articles
