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The 4% rule is one way of estimating how much income you can take from your retirement portfolio each year and be pretty sure it won’t run out. It is often referred to as the “Safe Withdrawal Rate”, or the “4% rule of thumb”.
All models are wrong, but some are useful. The 4% rule is one simple model to help estimate how much you need to save to be prepared for your retirement. It is a useful model but should NOT be the only retirement planning you do.
The 4% safe withdrawal rate is based on a study conducted at Trinity University by 3 professors of finance. This study is often referred to as the “Trinity Study''. The goal of the study was to determine, what is the highest, inflation adjusted percentage you could take out of your retirement portfolio each year, over a 30-year period and be assured you would not run out of money by the end. It turns out, that percentage was 4%.
This means for every $100 of assets you have in your investment portfolio, you can take $4 of annual, inflation adjusted income. Some alternative ways to look at this same math include:
Let’s go through a hypothetical example. Let’s say you wanted to be able to have $60,000 of gross income each year for retirement. And your guaranteed income from social security, pensions or annuities will be $20,000. This means there is a $40,000 gap between guaranteed income and desired income. To estimate how much we need to have saved, we simply multiply our desired additional spending by 25. This means $40,000 * 25 = $1,000,000. According to the 4% rule, we should save one million dollars to be pretty sure we can have lifetime, inflation adjusted income.
This rule is not foolproof, but it can be a good starting point. If you are retiring earlier, you may need to save more. If you are working until later in life, you may be able to get away by taking a higher withdrawal rate. Finding the answer to, “How much can I spend in retirement?” can be a nuanced, very personal question. If you would like some help from an experienced CERTIFIED FINANCIAL PLANNERTM, that specializes in retirement income planning, feel free to give us a call or send us an email. Ask for a complimentary financial review.