Contributed by John E Rice CFA, CFP® This article builds on the theme of my June article “Will You Have Enough Money to Retire?” In the June article I outlined how savings at least 20% of your annual income throughout your working years should leave you with enough money to retire. This article introduces a method to check if you are on track with your savings plan as you get closer to retirement age.
Let’s say that you are 55 years old and plan to retire at age 65. But you are not sure if you will have enough money saved by then. How can you check this?
With some very basic math and another “rule of thumb” (like the 20% rule) you can easily check if you are on course. I need to introduce another concept in this article for purposes of doing a quick check on your retirement savings. And that is the 4% rule.
Simply put, the 4% rule states that you can spend 4% of the starting value of your portfolio annually during retirement.
Building on the example in my June article, let’s say you have worked up your budget, your income from other sources, and have determined that in the first year of retirement you will need to withdrawal $180,000 from your portfolio. Using the 4% rule we can determine that you may need $4,500,000 accumulated by age 65.
$180,000 divided by 4% = $4,500,000.
You will want to have a retirement nest egg of $4,500,000 at the start of your retirement so that you can withdraw $180,000 in your first year of retirement and then increase your withdrawals by inflation each year. You may be aware that there is a rather lengthy debate about the 4% rule that has been going on since it was first introduced.
A planner by the name of William Bengen, CFP®, is credited with introducing the concept in the 1990s. His initial work, published in the Journal of Financial Planning in October 1994, looked at historical 30 year periods and determined that a portfolio invested in stocks and bonds could use this 4% rule over 30 year historical periods without running out of money.
This study has been replicated in many forms and variations over the years and there is wide ranging discussions on the subject, but for the most part planners agree that the 4% rule is a good guideline for the relationship between your retirement nest egg and future spending.
The trouble with using a rule based on historical models is the uncertainty of investments. What if you have 10 or 20 years of very poor performance on the front end of a 30 year retirement? This would eat away at your nest egg and leave you with potentially catastrophic results.
However, if we use a “reasonable” rate of return and assumptions in our models, there is a good chance to come out with good results and it is possible you might even be too conservative and spend less than you need to.
So I am going to outline how you can use the 4% rule to quickly check where you are at with your investments.
You are 55 years old and you have established that you will need a nest egg of $4,500,000 to live comfortably in retirement. If you have $2,000,000 saved now you can do a simple time value of money calculation to determine how much you need to save each year to get to $4,500,000 in ten years. Hint – A 6% return will almost double your money in ten years so you are not as far away as it first appears.
The calculation shows you will need to save an additional $70,000 per year over the next 10 years. Although this amount of savings may be daunting for some, if you are expecting to spend $200,000 in retirement then you are likely making $250,000 in the last few years of your working life (see June article). In this case, saving $70,000 may be 28% of your annual income.
Many people I talk to just don’t even want to think about this because it is can be too stressful or depressing to think about whether they have enough money to retire. My response is … “If you had a terminal disease would you want to know about it?” Then why would you not want to know how close you are to the financial goals you have set for yourself?
The 4% rule can be a useful guide to how you can check your path along the way.