The four percent rule, revised

percentThe venerated four-percent rule states that retirees can safely withdraw four percent of their retirement savings per year without running out of money in retirement. For example, if a retiree has $1 million in a retirement account, they can take out $40,000 the first year, and annually adjust that figure for inflation.

The rule was developed by financial advisor William Bengen in the 1990s and has become a standard measuring stick when figuring how much to save for retirement. However, many advisors are saying in today’s financial environment the four-percent rule may need revision. The returns on fixed income investments are much lower today than they have been historically.

The rule assumes that the return on a retirement account averages four percent per year. But when prevailing interest rates are historically low, this return rate may not be realistic. Withdrawing four percent annually, when you’re only getting two percent in your investments, increases the risk of running out of money down the road.

Another danger is that of a severe market correction at or near the start of retirement. Suppose the stock market corrects by 30%, and the retiree’s account drops from $1 million to $700,000. The $40,000 that the person had planned on taking out would now represent six percent of their savings. After dropping by 30%, the market would have to rise by 43% to get back to its original levels. By taking out a relatively large percentage each year, the retiree depletes funds that otherwise would have been left in the account to participate in the recovery.

The performance of investments is most crucial in the few years immediately following retirement. Losses early in retirement are much harder to recover from than those later in retirement. That’s why some researchers recommend staying with mostly conservative investments at the start of retirement, and turn back to stocks in later years.

Meanwhile, how do you start a comfortable retirement when your account is mostly in fixed-income investments that are only returning two or three percent per year?

One way is to adjust your expenses to compensate. Eliminate most large, fixed expenses before you retire – pay off your mortgage and car, get any major home renovations done, and don’t take on any more large debt by buying another home or a yacht. Your other expenses like travel, commuting, and eating out are more flexible. You can more easily cut back on travel and dining in restaurants for a while if needed. By leaving yourself this flexibility, you can be more ready for whatever the market throws at you, with less risk of outliving your savings.

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