3 Big Problems With the 4% Rule
One of the most difficult challenges for many retirees is developing a distribution strategy from their retirement assets. If you’re like most retirees, you’ll need some level of income from your savings and investments. You will likely have Social Security income and may even benefit from a pension. However, it’s likely that you may also need income from your savings.
It can be difficult to know just how much to take in distributions. If you take too much, you could deplete your savings and put yourself in a challenging financial situation later in life. Take too little, and you may struggle to cover your living expenses.
A common piece of financial wisdom is to withdraw 4 percent of your savings balance each year as income. The idea is that 4 percent is a modest and manageable withdrawal amount, and that it won’t deplete your savings. Many people also use this rule of thumb because it’s simple and easy to calculate.
However, it may not be the best approach for you to use in your planning. Below are a few reasons why the “4 percent rule” might not be right for you:
1.) It may not reflect inflation or market downturns.
One of the biggest issues with the 4 percent rule is that it usually results in a static distribution amount. The idea is that you calculate 4 percent of your balance each year to account for changes in value. If your balance goes up, so does your withdrawal. The same should be true if your balances decline.
However, the truth is that many retirees fail to do this annual analysis. Instead, they set a 4 percent withdrawal rate and then leave it constant. This can be problematic for a couple of reasons. First, inflation will likely raise your cost of living over time. You may need to raise your withdrawal amount periodically to keep up with higher costs.
Perhaps a bigger threat, though, is the failure to account for volatility. If you set a 4% withdrawal amount and then don’t change it, you could face a problem if your balances decline. All of a sudden that withdrawal amount could represent more than 4 percent, and that could lead to a depletion of your assets before you intended.
2.) It doesn’t take your allocation into account.
Another potential issue with the 4 percent rule is that it doesn’t account for your allocation. It’s possible that a 4 percent withdrawal could be modest if you’re achieving growth in your account. However, if you’ve invested in assets that have low risk and little growth opportunity, a 4 percent withdrawal could be high.
Your withdrawal amount should be based on your specific needs, goals and objectives. It should also be aligned with your allocation and investment strategy.
3.) It’s not specific to your spending needs.
Finally, the biggest issue with the 4 percent rule is that it may not be the appropriate withdrawal amount for your objectives. Perhaps you want to enjoy the first several years of retirement and then cut back as you get older. Maybe you want to be frugal in the early years to maintain a nest egg for later. Perhaps you plan on working part time to limit your withdrawals.
There could be any number of factors and criteria that influence your income needs. A better approach may be to build a budget that includes your specific spending goals and your projected retirement income. Then you can determine exactly how much income you should take from your savings each year.
Proper distribution planning is key to making sure your money lasts as long as you do! Simply resorting to a one-size-fits-all “rule of thumb” like the 4% Rule may be better than not planning at all, but it will not necessarily help you achieve your specific retirement goals.
To develop an appropriate distribution strategy that meets your needs, you should consult with an experienced retirement planner. Contact us today to request a free initial strategy session. We can help you analyze your needs and implement a plan that will help you achieve your short and long-term financial goals and objectives!
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