Motley Fool
0
All posts from Motley Fool
Motley Fool in Motley Fool,

3 Serious Problems With the 4% Retirement Rule

Image source: Getty Images.

If you're planning for a future in which you'll be able to live off retirement savings, you may have considered using a rule of thumb known as the "4% rule" to map out future withdrawals.

The 4% rule supposes that a retiree's investment portfolio is equally split between stocks and bonds, and it works as follows: In year one of retirement, the retiree withdraws a cash amount equal to 4% of his or her portfolio. In year two and onward, the retiree continues to withdraw 4%, after adjusting for inflation. In theory, following this plan will provide for at least 30 consecutive years of withdrawals.

Using the 4% rule can help an investor ration out a nest egg annually while holdings continue to appreciate and earn interest. Nonetheless, the formula has three serious problems investors should consider before relying on it to fund a complete retirement. We'll examine these problems, and how to approach them so that you can still make use of this robust tool.

Problem 1: Interest rates are upending planning assumptions

When the 4% rule was developed, interest rates were much higher than they are at present. For example, in the mid-1990s, when financial planner Bill Bengen first introduced the rule, the federal funds rate hovered near 6%.

Since the financial crisis of 2008, we seem to be caught in an extended period of extremely low interest rates, partly because of the desire of global central banks to keep near-term interest rates near zero, in order to maintain a growth-stimulating environment. The current federal funds rate is currently just 0.50%. 

Consequently, the yield that bonds should supply to the investor has diminished, tempting many to cut back on bond investments -- a move that can potentially increase portfolio risk.

Problem 2: The 4% rule is linear, but life isn't

The ingenuity behind the 4% rule -- that is, the modest, linear nature of withdrawals -- is also its most serious shortcoming. Investors sock away retirement funds not only to provide income at a future date but also to have resources to pursue a meaningful life post-employment. This may encompass travel, going back to school for further degree or non-degree education, or other pursuits the saver has looked forward to.

The 4% rule doesn't really address the greater need for funds of the relatively young retiree -- say, a 65-year-old -- versus an older retiree who may be more content with a fixed monthly income. 

Problem 3: Taxes and fees aren't included in the formula

Taxes are always important to consider when projecting out your future retirement funds. If a large part of your nest egg exists within a Roth IRA, you have relatively less exposure to the taxation of withdrawals, since you've funded your retirement with post-tax earnings.

But for many, the effective tax rate that's paid on traditional IRA funds, 401(K) plans, and so on in retirement is essentially a reduction of cash available from the annual 4% taken out.

Fees also aren't considered in the 4% calculation. If your entire portfolio consists of the lowest-cost equity and bond index ETFs you can find, congratulations. But for most investors, holdings are spread across a variety of instruments, and advisory fees, expense ratios, and the like should be considered when projecting out long-term returns.

How you can use the 4% rule to your advantage

Sure, there are significant caveats to the 4% rule. But while not foolproof, the formula has proved to be an effective planning method since it was introduced roughly 22 years ago. Given the potential drawbacks, consider implementing these steps:

1. Don't shy away from bonds completely. Coupon payments are indeed lower than they've been in years, yet bonds provide a counterbalance to equities holdings, and in many market cycles, they have tended to rise when stocks fall. You can also seed your equity portfolio with conservative blue-chip companies sporting dividend yields in the 3%-4% range, to supplement diminished bond income.

2. If you look forward to some discretionary expenditures at the outset of your retirement, consider a 4%-plus strategy, in which you build a fund independent of your primary retirement basket. Going through this exercise will help you prepare for possible front-load withdrawals you'll take in pursuing cherished post-retirement goals.

3. Grasp the effect of taxes on your future withdrawals, and work backwards. If you'll be living off blended retirement income, such as Social Security, pension payments, and your own savings, it's a good idea to understand what your yearly tax bite might look like on the income you'll draw.

Many online tax calculators exist to help you plug in expected income to get a sense of your effective tax burden in the future. Of course, this will be estimated at the tax rates in existence today. It's hard for us to project what tax rates will look like years into the future, but current tax tables are a decent place to start -- you can always adjust as you go along. This exercise will help you estimate actual cash you'll have available as income each year.

As for fees, you'll have to do the homework of learning how much you're paying in expense for ETFs, mutual funds, and managed accounts (and don't forget trade commissions). As a larger point, it never hurts to project your return on investments net of fees.

If I haven't completely scared you away from this retirement planning tool, you'll find, like the tax calculators, a host of 4%-rule calculators easily available online. Factor in the caveats we've discussed here, and give the 4% rule a shot -- it's a great way to gain perspective on the income you'll need when it's time to begin that next phase of life.

The $15,834 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $15,834 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.

Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.