Public speaking. Spiders. Heights. Being without your cellphone (yup, “nomophobia” is legit). Most of us have something we’re afraid of.
How about running out of money in retirement? Nearly half of people planning for retirement are worried about outliving their savings, according to a recent study by the American Institute of CPAs.
So how do you know how long your money will last in retirement?
One commonly used guideline is the so-called “4 percent rule.” In a nutshell, you can withdraw 4 percent from the total value of your retirement savings in the first year that you retire. Then, you can continue to withdraw the same amount, adjusted each year for inflation, each following year and have a reasonable level of assurance that your portfolio will last at least 30 years. Here’s how the math comes together:
Assume you have $1 million saved for retirement.
Year 1: You’d withdraw $40,000 from your savings (.04 x $1,000,000).
Year 2: You’d boost your withdrawal to account for inflation. For example, if inflation is running at 2 percent, your second-year withdrawal would be $40,800. (0.04 x 1.02 x $1,000,000)
Year 3: If inflation moves to 3 percent, you’d increase your withdrawal again based on that amount ($40,800 x 1.03) to $42,024, and so on.
The flip side, you can also use the 4 percent rule as a quick way to calculate how much savings you’ll need to generate within a certain amount of income.
For example, let’s say you’ve determined that you’ll need $60,000 a year from your savings to live comfortably in retirement. Based on the 4 percent rule, you’d divide $60,000 by .04 (or simply multiply by 25) to determine that you’d need a nest egg of approximately $1.5 million to afford the lifestyle you want.
RELATED CONTENT: How much do I need for retirement? Our retirement planning guide can help you better understand the road to retirement — and how to craft a financial plan that’s built around your unique goals.
DOES THE 4 PERCENT RULE WORK FOR RETIREMENT?
Like any generalized rule, there are critics who question whether you can still use the 4 percent rule for retirement today.
For starters, it assumes a 30-year retirement. What if your retirement stretches longer (lucky you)? A 4 percent withdrawal rate might cause you to deplete your savings late in retirement. Conversely, what if you love your job and continue working into your 70s? Sticking to the 4 percent rule might result in a retirement that’s more frugal than necessary, depriving you of some of the luxuries you worked hard to afford.
The 4 percent rule also assumes that you have a 50/50 portfolio of stocks and bonds. That mix made sense in the 1990s when William Bengen created the rule and bond yields were higher than they’ve been in recent years. Depending on your feelings about risk, your portfolio may be more focused on stocks or on bonds, which would impact its performance.
For these and other reasons, it’s important to use the 4 percent rule as it was intended — as a starting point for determining the best way to create a sustainable stream of income from your savings.
As you approach retirement, it’s important to move from rules of thumb and create a precise plan that is specific to your lifestyle goals. For many, that’s where expert help can make a difference. A financial advisor can help you create a retirement income strategy to make your money last for years while affording the things you enjoy.