Everyone experiences their retirement differently, but we all have one goal: to ensure that we can make ends meet with our pension savings for a long time.
The 4% rule is probably the go-to guideline for determining how quickly you can spend your savings. It states that a retiree can withdraw 4% of the original value of their savings each year, adjusted for inflation. In other words, someone retiring with $1 million would withdraw $40,000 each year, increasing it slightly each year to account for inflation.
It's a good starting point for developing some basic frameworks, but it's hardly a retirement plan. The problem with painting with broad brushstrokes is that you never fill in the finer details.
There are some considerations when applying the 4% rule and some essential tips to ensure you have the right plan for your needs. Here’s what you need to know.
The 4% rule has some problems
I don’t want to knock the 4% rule, but people shouldn’t use it to plan their retirement finances. It’s a guideline, not an A-to-Z plan. Here are some potential problems with the 4% rule:
Market volatility is not taken into account
One of the biggest problems with the 4% rule is that it doesn’t take into account the market volatility that your nest egg can face. The stock market has historically averaged 8% to 10% annual returns, but those annual swings can be as much as 20% to 30% up or down in any given year.
Suppose something happens and your savings take a big hit the year you retire or shortly thereafter; mathematically speaking, you will deplete your savings faster. Luck plays a role in investing that the 4% rule doesn’t account for very well.
Some living costs may rise faster
Housing and healthcare are major living expenses for most retirees. Both have skyrocketed since the pandemic, and it’s hard to predict what those costs will look like years later in life.
Unfortunately, America’s sky-high debt burden means that future retirees, especially those with decades to go before retirement, shouldn’t assume that Social Security like Medicare will cover as much as it does today. Whether it’s healthcare, food, transportation or housing, essential living expenses could realistically trump the 4% rule.
It's not specific to you
Finally, the 4% is a general guideline, not tailored to your financial situation. The typical American worker retires between 63 and 65 with a median savings of $200,000. You may have saved more or less, or retired earlier or later than average.
You can get away with sloppy planning early in your retirement, but you could be in big trouble if your savings dry up years down the road when you’re too old to work. Plus, you don’t want to scrimp and save your whole life and then leave a ton of money on the table because you were too conservative.
Consider these possible changes
The 4% rule gives you a basic idea of what your retirement lifestyle will be like, but you shouldn’t stop there. Consider these additional tips to help you live your best retirement possible.
Evaluate your timeline
The 4% rule is designed to stretch your savings for at least 30 years. However, the math may be off. The average life expectancy in the U.S. is 77 years. In other words, the average person lives about 12 to 14 years after retirement. The 4% rule may be too conservative unless you retire early. Consider creating a retirement plan with multiple time frames in mind. You want to know if your savings will last without restricting your lifestyle to the point that it harms your quality of life.
Re-examine your investment strategy
Many people retire with less than they had hoped for. However, your savings don’t stop growing once you retire. You may be able to grow your portfolio during retirement by adjusting your investment strategy. The 4% rule assumes a portfolio that is 60% stocks and 40% bonds. You should never take more risk than you are comfortable with, but being a little more aggressive can make a big difference in your retirement portfolio in the 10 years after you retire.
Consider dynamic spending
Finally, the 4% rule assumes that you withdraw roughly the same amount from your savings each year. As mentioned earlier, a market downturn can disrupt your retirement plans. If your finances allow it, consider a dynamic system where you withdraw smaller amounts when the market is down and larger amounts when it is up. That might mean making some simple lifestyle choices, like saving that big vacation for when the market has a good year or letting that old car last a little longer. These small changes can make your savings last years longer.
Any questions? Consult the professionals
Retirement planning is a complex topic. If you have questions or feel overwhelmed by the process, don’t hesitate to consult a professional advisor. While it will cost you some money to get professional advice, the benefits of an effective retirement plan will far outweigh the cost.
Retirement planning is the financial foundation for much of your life. Skimping on preparation or taking retirement lightly will only hurt you and could cost you thousands of dollars in taxes and opportunity costs. Knock your retirement plan out of the park by going beyond the 4% rule.
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Forget the 4% rule? Here's what you really need to look at in retirement. was originally published by The Motley Fool
