Understanding the Four Percent Rule

Understanding the Four Percent Rule

Whether you’re close to retirement or decades away, chances are you’ve had the opportunity to contribute to an employer-sponsored retirement savings plan such as a 401(k), IRA, or something similar.

When you retire, you will likely rely on these accounts as a source of income. The question is, have you thought about a withdrawal strategy to carry you through your golden years? There are a few different options available including fixed-dollar or fixed-percentage withdrawals. But, according to financial advisor William Bengen, the Four Percent Rule is the answer.

After conducting a study in 1994 on the historical data of stock and bond returns between the 1930s and 1970s, Bengen determined that withdrawing 4% of the total retirement funds annually from a retirement account would be sufficient for participants without exhausting a portfolio for at least 30 years. Today, participants following this rule should increase their total withdrawals by 2% each year to account for the Federal Reserve’s target inflation rate.

How Does the Four Percent Rule Work?

To use the Four Percent Rule in retirement, participants would withdraw 4% of their retirement savings within the first year of retirement and adjust the dollar amount for each year after to account for inflation. This tactic ensures that retirees will not run out of retirement funds for at least 30 years.

To adjust for inflation, retirees have a couple of options:

  • Set a flat annual increase of 2% each year to align with the Federal Reserve’s target inflation rate. This option provides steady increases for participants.
  • Adjust withdrawals based on actual inflation rates, which can be more effective in matching income to cost-of-living changes over the years.

If you’re unsure of which path to take, talk to a financial advisor to determine which works best for you and your finances. You can also use the Four Percent Rule calculator to help you determine the savings required to withdraw annually.

Advantages of the Four Percent Rule

Using the Four Percent Rule has advantages for retirees:

  • The Rule is easy, straightforward, and simple to use.
  • It provides a predictable and steady income for people in retirement, as well as the peace of mind knowing their funds will not be exhausted for at least 30 years.
  • It helps retirees keep a consistent withdrawal schedule without overextending their funds.

Using the Four Percent Rule

While the Four Percent Rule is a helpful retirement tool, there are a few things to keep in mind when using it.

  • Keep an eye on the market. Major market downturns can diminish the value of accounts, so by staying up to date with trends, you can make better investment and withdrawal decisions.
  • Be consistent with withdrawals every year. When you increase or decrease your withdrawal amount, the principal and compound interest are affected. By maintaining a 4% withdrawal each year, you keep a steady account.
  • If you’re eligible for early retirement, you may need to adjust the amount you’re withdrawing each year. Speak with your financial advisor before getting started.

Because of the timeline of when the rule was developed, you may be wondering if it’s still an effective tool to use for today’s retirees. The short answer is yes, but some adjustments should be made, according to Bengen.

While the original Rule was based on stocks and bonds, Bengen notes that small-cap stocks should be included in today’s calculations, allowing for up to 4.5% to be withdrawn safely on an annual basis. To learn more, read Barron’s interview with Bengen here.

If you’re unsure of how to approach your retirement accounts, talk to a financial advisor to determine the best plan for you and your family. And if you’re looking for educational resources along the way, subscribe to the Slavic401k blog to learn more.

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