The 4% rule is a common discussion when it comes to retirement income and stability. The rule is a simple and straightforward one which says that all you need to do is keep your withdrawal rate for your retirement savings less than or equal to 4% so that you don’t run out of money in your lifetime. This rate is also known as the safe withdrawal rate and is precisely defined as the rate at which you can spend your retirement money to remain safe and well financed throughout your life. Now, you might be thinking why it is discussed so often and deeply. It is just so simple and uncomplicated – why would people think about it in so much detail? The answer is that it is not as uncomplicated and simple as it seems but there are certain complications.
These complications include that it is practically impossible to guarantee that the rule will be effective considering the future is unknown to us. We do not know how much things will cost in the next few decades. What if the economic condition is very poor and unhealthy during that time? Will the remaining money still be sufficient for your needs when you can’t work like you do now? Things were available at a lot lesser cost in the past and now they are so much more expensive. The reason this happens is because inflation is a persistent and ongoing thing. The prices keep increasing so you may never know when that 5 dollar carton of milk will start costing you 50 dollars!
Now, where did this number 4 come from? What is the significance of this magic number and why do some financial advisors suggest that spending 4% of your savings is ideal? Why not 3? Why not 7? The reason is that they focus on all the retirement savings you might have in the form of stocks and other assets. These pay you dividends at a total rate of about 7% and one can predict that inflation will eat almost 3% of that money. Therefore, the difference is 4% which you can spend without worrying too much.
However, the risk of breakdowns is pretty high and one cannot exactly predict when a certain event will happen. This is why such a magic number might not be an exact and great depiction of how you should be managing things. So, what can we do?
There is a series of calculations which is known as the Trinity Study which was carried out by a man named Wade Pfau. He came up with a prediction of what maximum safe withdrawal rate had been for various retirement years. In his chart, one could easily see that 4% rate was actually pretty stingy and people could spend a lot more – as much as 5% – of their savings each year and still end up with an enormous amount of money. The past teaches us a lot and this only goes on to tell us that the fact that the 4% rule may have been a favorable one in the past does not really mean that it will be such in the future! This because the Trinity Study was carried out for years when the United States was in its boom years, that is, the economy was strong and at its best. Good years can be a possibility but to base your expectations on something like this is risky, to say the least.
Also, during the years for which this study was carried out, the oil resources were much cheaper. Fossil fuels were cheap at that time and economic growth was based on them. Do you really think the scenario is going to be the same in the near future?
There is a possibility of hyper inflation during which health care prices could skyrocket. What would you do then, if you fall sick? This rule is more of a general one and does not really take every individual into consideration. Everyone has different needs and it is possible that someone might need a lot more health care than others. Such is life and using a one size fits all approach does not really benefit anyone in the end. Even the things which were stated above cannot be predicted. It is a matter of optimism and pessimism which is not a financial debate. These unprovable points should be set aside and the rule we should follow should be based on our needs. So, the final question is, is the 4% really worth it? Should you follow it?
In a few ways, yes it is. In fact, the rule is one of the most conservative approaches because you need approximately 25 times the amount of money you spend currently for your retirement. That is a perfect goal to save for. If you are a heavy spender, it is possible that your habits will not change in the future so you have to save accordingly. Consequently, you could also reduce your spending in the current scenario so you can meet your goal much more easily. You can also retire early if you bring down your expenses to a lesser amount.
A good approach would be to follow the safety margin rule. In other words, you have to maintain a margin of safety like those in the stock market which can be defined as the difference between the intrinsic value of a stock and its market price. Such rules make it safer to follow the 4% rule which can be a little scary for many of us.
Understanding how to properly prepare for retirement is vital in today’s markets. A guide for the transition is often helpful, including annuities. Getting tips on a healthy and happy retirement from a trusted source is highly recommended.
A good retirement plan will leave you rich and living a good life long after you stop working. Good luck!