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Retirement Spending – the 4% Rule

Are you saving enough for retirement? This is a difficult question to answer. It boils down to how much money you will need in retirement to maintain an acceptable lifestyle. One challenge is that unless you are fairly close to retiring, you probably don’t have a good grasp of what your desired lifestyle costs or what your retirement spending patterns will be. How much you need to save is directly related to how much you plan to spend.

Another challenge is income. Will you have sources of retirement income, such as Social Security or a pension? A steady source of guaranteed income in retirement can dramatically lower your savings requirement. But you need to take into account that a lot can change in the future, and what you thought was a “guaranteed” source of income could turn out to be less reliable than you thought.

Also, how is your health and family history? Many studies on retirement spending assume a 30-year retirement. Assuming you retire at age 65, is it realistic to believe that you or your spouse will live to be 95?

Even taking these complexities into account, there are accepted rules of thumb regarding retirement savings and spending. This blog post explores something called the 4% rule.

The 4% Withdrawal Rule
The 4% rule basically states that you can safely spend 4% of your savings during your first year of retirement. For subsequent years, take the dollar figure from the first year, and increase it by the inflation rate. For example, if you retire with $500,000 in savings, you could spend $20,000 from savings in your first year of retirement (4% * $500,000 = $20,000). Assuming inflation during the year is 2%, you could then spend $20,400 in your second year of retirement ($20,000 + ($20,000 * 2%) = $20,400). Under this system, you continue to grow your spending each year by the prior year’s inflation rate, regardless of what is happening with your investments. Keep in mind this is spending in addition to any income you are getting from Social Security or a pension.

Although a 4% withdraw rate is a good rule of thumb to keep in mind while saving, for most people, I believe the assumptions behind this figure are probably too conservative. Studies that arrive at a 4% rate for safe withdrawals generally assume a 90% probability of success (i.e., that your savings lasting through retirement) and a 30-year retirement period. The analysis assumes you remain invested in a diversified portfolio of stocks and bonds. Your odds of success would be far lower if you invest in a highly conservative portfolio of bonds and/or CDs.

Implications
Let’s think for a minute about what these assumptions imply. For one, as I mentioned above, if you retire at age 65, the assumption is that you will live to 95. Considering that the life expectancy for a 65 year old in 2010 was 19.1 years, only a small percentage of people will reach 95 (Center for Disease Control; Health, United States, 2012). Specifically, according to the U.S. Social Security Administration’s Periodic Life Table (2009), less than 7% of 65 year-old males and 13% of females will live to 95. And these percentages assume you make it to age 65 in the first place.

Secondly, the analysis is based on a 90% probability of your money lasting until age 95. Said a slightly different way, this means there is almost a 90% probability you will still have money remaining even after 30 years of withdrawals. In fact, in most average scenarios (or the 50% probability case), your savings will have increased and you will have more assets than you retired with.

Conservative assumptions are used for these studies to address people’s fear of running out of money. I don’t think most people would be comfortable implementing a financial plan if there was a 50% chance that they would be broke past their life expectancy date. The prevailing assumption seems to be that it is better to be conservative in your retirement spending to ensure you can maintain a constant spending level throughout retirement.

Alternative Approaches
A number of alternative withdrawal rules have been proposed. Most of them start with a slightly higher rate (e.g., 5% in the first year), but adjust the spending based on performance of the investment portfolio. So for example, if the market declines in your first year of retirement, perhaps you don’t increase your spending for the next year. These alternative approaches allow a retiree more income early in retirement, but lack the simplicity of the “4% rule” and may require you to curtail spending if your investments are performing poorly. Frankly, I think this is a more natural human tendency than continuing to withdraw increasing amounts from a declining investment portfolio.

Getting back to the original question, how much should you be saving for retirement? Even with all its flaws, the 4% rule is a good basis for retirement planning if you are still mid-career. Hence, if after Social Security and any pension income, you want your retirement savings to support another $2,500 per month in spending, you should target a nest egg of around $750,000. We arrive at this figure by dividing the desired annual spend of $30,000 (12 months * $2,500/month = $30,000) by 4%. If you’re comfortable being a little more aggressive, perhaps you’ll want to start with a 5% withdrawal rate, which would require $600,000 in savings.

Retirement Projections
For those closing in on retirement, I would suggest a more detailed analysis to determine an appropriate spending rate. Your financial advisor can work with you to run retirement projections that are tailored to your individual situation. Customized “cash flow” modeling can take into account personal factors such as: other income sources, marital status, staggered retirement dates, expected investment returns, family health, etc.

Additional Resources:
Here are a few links with additional details on safe withdrawal rates in retirement:

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