If you know only one basic strategy for spending down your savings in retirement, it’s probably the 4% rule.

It was developed 40 years ago by financial adviser Bill Bengen. The basic idea is that retirees can safely withdraw 4% of their nest egg each year, adjust for inflation as they go along, and have a 95% chance that they won’t outlive their savings.

The financial research firm Morningstar ran 1,000 simulations of future market conditions and released a study. They found that the 4% rule is still relevant and effective in doling out a retiree’s money safely and efficiently 90% of the time.

 

How Does the 4% Rule Work?

 

The concept is pretty simple. You can withdraw 4% of your savings in your first year of retirement.

For the sake of easy math, let’s say you have $1 million socked away in your retirement and other accounts. In that first year, you would have $40,000 to spend – plus any Social Security, pension, and passive income you receive.

In the second year, you adjust for the rate of inflation. In this example, let’s take a 3% inflation rate. In year two, your withdrawals would total $41,200 (40,000 x 1.03). Keep doing that each year: take the previous year’s total and add the inflation rate.

The idea is that your purchasing power would remain the same, and your money will last for a minimum of 35 years and probably longer.

The plan assumes you have a 60/40 allocation of stocks and bonds – 60% stocks and 40% bonds – although a 50/50 allocation also works. The Morningstar calculation is based on a more conservative allocation of just 20 to 40% equities.

 

Why Are There Doubters?

 

Of course, we are much better at predicting the past than the future.

The biggest risk to the efficacy of the 4% rule is a lousy market in the first year or two of retirement. The risk of a sharp market decline in those early years, known as the “sequence of returns risk,” can blow a big hole in this strategy.

If that same market downturn occurred later in your retirement, it would not have the same negative impact.

While the 4% rule tries to account for inflation, a super-charged surge in prices could have an impact that is just as significant as a lousy market. Bengen tried to account for that by recommending that a person do some belt-tightening in times of trouble and reduce withdrawals by about 5% to preserve your portfolio’s odds of outlasting you.

Some doubters of the 4% plan also believe you need to reduce your spending in conjunction with a steep market downturn but spend more when a bull market is raging.

 

The Bottom Line 

 

Another rule that applies here is that no one-size-fits-all plan works for everyone. You need to find the right balance between spending too little in retirement and spending too much.

Your situation should factor into your strategy, including the age at which you retire and your health. Also, most of us don’t spend the same amount year after year. Very often, people spend more early in retirement when they travel and generally “live it up.”

The 4% rule can be a starting point or guidepost for your retirement, but it is pretty rigid and does not always meet everyone’s needs. Your situation (and expenses) will likely change over the decades of your retirement, and you need to be flexible and nimble enough to adjust to meet those changes.

Everyone’s situation is different, especially when you factor in health, life expectancy, expected return on investments, and expenses.

Contact your financial advisor for your financial planning.

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