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The 4% Solution

By on February 21, 2013
Categories: RETIREMENT

What is the likelihood that I’ll outlive  my nest egg?

Investors are likely to start asking some variation of that question when they are nearing retirement.

And it’s understandable since saving for retirement seems far more straightforward than figuring out how much you can spend in retirement, especially during turbulent times.

The good news for people contemplating retirement is that they don’t have to make wild guesses about how much money they can safely withdraw from their retirement accounts. Well-respected financial experts, who have spent a great deal of time researching this conundrum, have crunched the numbers for you.

For several decades, these experts have been exploring how retirees can safely live off their hard-earned savings while preserving as much of it as possible during varying market conditions including booms and busts.

A Safe Withdrawal Rate

The general consensus of these researchers is that an investor can withdraw roughly 4% of his or her retirement accounts for 30 years with a very low risk of running out of money. The financial industry has widely embraced this 4% guideline.

Let’s take a look at how a 4% withdrawal strategy would work:

A couple has decided to retire with $1 million in investable assets. During that first year in retirement, the couple would remove 4% of their nest egg or roughly $40,000.

Once that initial calculation is done, the couple would discard the 4% figure and instead adjust their initial withdrawal for inflation for the next year. If the inflation rate is 2% the following year, the couple could pull out a total of $40,800. The couple would adjust withdrawals for inflation every year after that.

With this withdrawal rate, a person could have survived such calamitous times as the Wall Street crash of 1929, the Great Depression, the dot-com meltdown and the most recent bear market that stretched from 2007 to 2009 without running out of money.

Just 4%?

It’s understandable if you consider this target withdrawal rate skimpy. Whether you should stick with a 4% withdrawal rate will depend on many factors:

  • Length of your retirement. If you retire later in life, the withdrawal could conceivably be larger.
  • Your asset allocation – the mix between stocks and bonds.
  • Your ultimate financial goals. Do you want, for instance, to leave an inheritance for your children?
  • Your life expectancy.

We’ll expand on the topic of withdrawal rates in the next post.

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