If you are on the edge of retirement or a current retiree, you are probably familiar with the phrase, the Four Percent Rule. The concept is used to help you and fellow retirees manage your finances in your golden years.
As a retiree, you said goodbye to a steady paycheck from an employer. Although you are no longer punching the clock, you still have to pay your bills and manage your finances. This can be a stressful task when you no longer have a traditional income to count on. The Four Percent Rule is a guide to help you do the math in order to live your life in the present and prepare for the future. William Bengen, a financial advisor, published the theory in his paper, “Determining Withdrawal Rates Using Historical Data” in the Journal of Financial Planning in 1994.
“The Four Percent Rule was created using historical data on stock and bond returns over the 50-year period from 1926-1976. Before the early 1900s, experts generally considered 5 percent to be a safe amount for retirees to withdraw each year,” according to Investopedia writer Julia Kagan.
The Four Percent Rule recommends retirees withdraw four percent of their savings in their first year. Every year after that, retirees should withdraw the same amount in dollars, adjusting for inflation, according to NerdWallet writer Andrea Coombes.
“Possible ways to adjust for inflation include setting a flat annual increase of 2 percent per year, which is the Federal Reserve’s target inflation rate, or adjusting withdrawals based on actual inflation rates. The former method provides steady and predictable increases, while the latter method more effectively matches income to cost-of-living changes,” according to Kagan.
Some retirees, though, keep their withdrawal rate constant year after year, she notes.
The Four Percent Rule seems like a simple concept, but retirees should be careful how they apply the method to their retirement savings. Rob Berger, contributing editor for Forbes Advisor, says the four percent withdrawal rate only applies to your first year of retirement, with inflation setting the rate for subsequent years.
“The goal is to maintain the purchasing power of the 4 percent withdrawn in the first year of retirement,” he adds.
The simplicity of the Four Percent Rule makes it an attractive concept to adopt. However, for it to be successful, you have to understand that it is based on specific assumptions, such as a portfolio that divides 50 percent of your savings into stocks and the other half into bonds, according to Berger.
Berger adds, “The rule rests on precise allocation constraints, while fees, inflation and sequences of returns risk can lead to varying outcomes when following the Four Percent Rule.”
Updated percentage rule
The 50/50 investment split between stocks and bonds that Bengen used in his original paper has recently been adjusted and reflects an asset allocation of 30 percent large-cap stocks, 20 percent small-cap stocks, and 50 percent intermediate-term Treasury Bonds, resulting in the 4.5 Percent Rule, reports Berger.
The Four Percent Rule or the updated rule can serve as a guide to help you plan your retirement. If you are unsure of how to apply the rule or need help managing your finances, seek out assistance from a reputable financial advisor or planner.
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