What the 4% Rule Means to You

The 4% rule is a key rule-of-thumb guideline in retirement planning. It helps you estimate how large a nest egg you need to have to cover your costs throughout retirement. Having a good handle on the 4% rule means you can map out the lifestyle you can expect in your golden years and make adjustments in your plan between now and then to better suit your needs.

To get started with the 4% rule, start by estimating the annual expenses you need your nest egg to cover once you stop drawing a paycheck. Divide that amount by 4%, and the result is the size your portfolio probably needs to be to cover those expenses over a 30-year retirement. For example, if you need your portfolio to cover $20,000 per year, you'd need to have $500,000 saved by the time you retire. In retirement, you can then spend that $20,000 in your first year and adjust based on inflation after that.

Why the 4% rule matters

Drawing down assets too quickly can easily force you to run out of money well before the end of your retirement. Over time, the stock market has provided annualized returns around 9.5%. The problem is that those returns aren't guaranteed and certainly don't come smoothly. The market can and does lose value from time to time. Once you retire and you need to start taking money out of your accounts to fund your costs of living, you can't wait for a bad market to recover to pay your bills.

On top of the risks that come from a bad stock market, retirees also have to deal with the risk that inflation will eat away at the purchasing power of their money over time. Over the past 30 years, inflation has eaten away over half the value of every dollar. An income that might seem perfectly fine today might be woefully short of what you need near the end of your retirement -- when you can no longer work to make up the gap.

How the 4% rule handles those risks

To address the risk of a bad stock market, the 4% rule indicates that your portfolio should be diversified between stocks and bonds. The original authors of the rule used a 50% stock-50% bond split. That way, when stocks were performing well, you could draw more of your costs from your stocks. When stocks weren't performing well, you could draw more of your costs from your bonds, which are generally around only one-third as volatile as stocks.

Unfortunately, bonds also typically carry with them lower overall expected returns. For instance, in today's low-interest-rate environment, U.S. Treasury bond investors need to look out 30-years to get long-term returns near 3%. Once you load up your portfolio with assets with lower expected returns, your overall expected return will drop as well. Consider that the price you pay for the higher certainty of actually having your money available to you when you need it.

To address the risk of inflation, the 4% rule has you spend a bit less than the overall expected return rate of your portfolio. For instance, if your stocks earn 9% and your bonds earn 3% and you have a 50% stock-50% bond portfolio split, your overall return rate would be around 6%.

If you expect to earn 6% on your money and only spend 4% of it along the way, you'd have a good shot of winding up with a little more money at the end of the year than you started with. That gives you a fighting chance to keep up with inflation over time. Granted, some years will be better and others will be worse, but all in all, over the course of a 30-year retirement, you'd still have a very strong chance of seeing your purchasing power last.

The downsides of the 4% rule

While the 4% rule has been time-tested, it still provides no absolute guarantees of success. Some argue that due to today's low interest rates, retirees are at a greater risk of running out of money because their bonds can't provide enough income to keep up. Others indicate it's probably too conservative a withdrawal rate, as people following the rule would typically wind up with twice as much as they had at the start of their drawdown period.

Despite the unknowns and the risks, the 4% rule is still an excellent guideline to plan around. After all, if you do amass the $500,000 nest egg it would take to provide $20,000 a year in inflation-adjusted income, you would still retire with far more than the typical American does.

Once you retire, if your money does grow faster than you need it to, you can always ratchet up your spending or your charitable giving. And if it does turn out that the 4% rule is too aggressive for today's market conditions, you're still likely to be able to live comfortably on that money during the younger, more active days of your retirement.

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The Motley Fool 17th October 2017