When people save for retirement they often have a mental target of a certain sized nest egg that will provide them a secure income for the balance of their lives. Nobody knows just how long they will live but they may have an idea of what the average life expectancy is. What if you live longer? If you are fortunate enough to be blessed with a long life, you wouldn’t want to outlive your retirement savings. Your nest egg must last as long as your longest expected life -- not your average expected life. If you retire at age 65 you might live another 40 years. Will you be able to draw a retirement income from your nest egg for 40 years?
The 4% Rule
The 4% rule was developed by financial planner William Bergen twenty years ago in 1994. He studied various withdrawal rates and asset allocations and how these affected an investment portfolio with a 30 year longevity. Bergen ran scenarios assuming that a person retired at the start of every year from 1926 to 1976 and tested to see if their savings were depleted prior to 30 year of withdrawals. The portfolios were invested 50% in stocks and 50% in bonds. Using an inflation adjusted 4% withdrawal rate over the 50 scenarios no portfolio lasted less than 35 years.
This 4% rule has been widely adopted as a rule of thumb by financial planners. You will find it cited by research firms such as Morningstar, brokerage houses such as Schwab, and asset managers such as T. Rowe Price. Over the past twenty years, several variations of the rule have evolved but the basic premise has remained unchanged. Over a thirty year retirement horizon with a 50/50 mix of stocks and bonds, you can plan on withdrawing about 4% of your initial investment each year as a retirement income.
How can I use this rule?
Use this rule to estimate the size of the nest egg that you must save towards retirement. What’s my number? First decide on how much income you will need to live comfortably. Remember that Social Security and pension incomes will provide a base and then you can top that up with income from your personal retirement plan. Say that maybe after these sources you will need $10,000 per year of income from your savings to live on. Using the 4% Rule you can calculate that you will need $250,000 invested in a portfolio of stocks and bonds to generate $10,000 per year of retirement income.
What’s the income replacement multiple? That’s the reciprocal of 4%. If I want to replace $10,000 in income, I multiply that number by 1 divided by 0.04 to get a 25 times multiple. I need to save 25 times $10,000 or $250,000. Knowing the multiple gives you a good idea of how much you need to save.
Just won a million dollars and think you are rich? With the 4% Rule you know that for a 65 year old who invests their $1 million dollar prize money in a portfolio of stocks and bonds this will generate a an income of $40,000 per year over the next thirty years. Comfortable, but not that rich!
How can you beat the 4% Rule?
Researchers have found two methods of reliably beating the 4% Rule.
First is obvious and is the path most often chosen by folks approaching retirement -- wait longer to start drawing income from your retirement funds. By postponing retirement, the savings grow and the drawdown period is reduced increasing the certainty that you will not outlive your savings. This may be obvious, but not the best solution as most folks would prefer not to work longer.
The second solution is not as intuitive. If the asset allocation is increased to 75% stocks, then the longevity of the retirement saving is increased and higher payout rates become feasible. Adding risky and volatile stock proportions actually increased the certainty that the savings would last longer. This is counter-intuitive, most people think that a more risky stock portfolio would increase the likelihood that you would run out of money, but the higher returns on the stock portfolio increase your probability of success.