How the 4% Retirement Rule Works

by on October 27, 2011

There is a pretty common retirement planning rule of thumb that says that you can withdraw 4% of your savings each year during retirement.  It is referred to as the 4% rule.  As with all rules this simple, there are drawbacks to using it as your only source of retirement planning, but when used with other methods it can be very useful, especially to come up with a quick calculation of how much money you’ll need to save to retire.

How the 4% Rule Works

The 4% rule of retirement is actually predicated on some fairly advanced scenario analysis that looks at historical markets, calculates odds of different movements over the years, and then gives a probability that your retirement savings will still be around after 30 years of retirement.  What the rule says is that, during retirement, you can withdraw 4% of your nest egg each month.  That means that for every The 4% Rule of Retirement Planning$100,000, you can spend $4,000 per year.  The rule also assumes that you withdraw a little bit more each year, based on inflation.  That means that if you have a one million dollar retirement account, you can withdraw $40,000 the first year.  The second year, you can withdraw $41,200, which assumes inflation of 3%.  In the third year you can withdraw $42,436, which is 3% more than year two.

If you continue to make these withdrawals, you’ll have a 90% chance of your money lasting 30 years.  The good news, is that you’ll also have a 75% chance of having 70% of your total starting assets.  As in, if you start with a million there is a 75% chance you’ll have at least $700,000 after 30 years.  There is a 50% chance that you’ll have $2 million after 30 years, and there is a 25% chance that you’ll have $4 million after thirty years.  These figures are based on how the market performs during your retirement.  If the market does average or well, you should have more money after 30 years than when you started.  This is because the market (stock and bond mix) averages over 4% per year.  If you would get historical average returns of over 7%, your money would grow quite dramatically.

How to Calculate Money Needed to Retire

By using this rule of thumb, you can easily reverse the calculation to determine how much money you would need to retire based on the 4% rule.  To calculate total retirement savings needed, multiply the amount of money you’ll need to spend in year one of retirement by 25.

For example, let’s say you will need $75,000 per year when you retire.  You will be expecting $20,000 in social security and a company pension of $10,000 per year.  That means you’ll still need an additional $45,000 per year.  Multiply this $45,000 by 25 and you get $1,125,000.  This is how much money you will have to save based on this rule of thumb.

What Else to Be Aware of About the 4% Rule

As with all simple rules of thumb, there are pros and cons to using it.  The pros are that it is easy to calculate and rather conservative in estimating how long your money lasts.  The cons are that the rule is rather conservative, and may calculate a nest egg amount that you are not able to save.

Another thing that can throw off this metric is any large market losses in the early years.  For example, if you save a million dollars and then your investments turn sour early in retirement, losing 10-30% could significantly reduce the chances of your money lasting deep into retirement.

Another reason some advisors fault this rule is because it doesn’t allow you to spend as much as other retirement guidelines suggest.  The fact that, using this rule, you have a 25% chance of doubling your money during retirement, means a lot of money that you don’t spend.  One way to adjust for this would be to increase your spending more during retirement.  Or, to use more than 4% for the first ten years of retirement, when you’re typically more active and may enjoy spending it more.

In summary, you should take the 4% rule with a grain of salt.  Look at your other assets, and if you have a lot in pensions and a lot of home equity, you can spend a little more freely than if your retirement account is your only asset during retirement.

{ 2 comments… read them below or add one }

Nia May 10, 2013 at 5:06 am

Hi,
Could anyone? Take an average person who has no knowledge of investing and see what they are doing for retirement. Impossible.

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MMD August 26, 2013 at 8:58 pm

The 4% rule is such a good metric to use and yet it is so highly disputed among so many financial planners. I personally use 3% just to guarantee myself a safety margin in my retirement planning. But I have read some pretty interesting theories that tell you that you can go even higher. For example, in the book The Smartest Retirement Book You’ll Ever Read, the author devotes a chapter to how when the economy as a whole is on an upswing or downswing, this can determine whether you should take out less than 4% or start off with a figure as high as 5%! Pretty interesting stuff considering it could really make a difference to your bottom line during retirement.
MMD recently posted..A Strategy for Getting the Most From Both a Roth IRA vs 401kMy Profile

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