What rules of thumb do you follow? Half a teaspoon of salt per serving when cooking pasta? One car length of spacing for every 10 mph? Eight glasses of water a day? Whatever subject you broach in everyday life, there seems to be a rule of thumb that helps you get started or provides a reference point. From Accounting to Zoology, every subject has educated estimates that allow us to survive when we’re not experts.
The financial world has rules of thumb, too, and one is garnering more scrutiny as many Americans look towards retirement. You may have heard about the “4% Rule” for retirement distributions, but few investors understand its genesis and its importance. Here is a quick primer for those that seek a deeper awareness.
While everyone’s retirement needs vary, the 4% Rule suggests limiting withdrawals in your first year of retirement to 4% of your investable portfolio balance. Thereafter, increase the amount you withdraw only to offset inflation. The goal is to minimize the risk of outliving your money.
Like all rules of thumb, this one has fine print. Here are a few common myths and misunderstandings about the 4% Rule:
1. One size fits all. A rate of 4% (four percent) isn’t a hard and fast rule that applies to every situation. Remember, it’s a rule of thumb. Differing needs and moving budgetary targets may dictate a different withdrawal rate for your plan.
2. The 4% Rule lasts forever. The 4% Rule is predicated on a 30-year time horizon – not perpetuity. Retirees need to be realistic about how long their money can last, even with modest income needs.
3. The 4% Rule will solve your portfolio construction equation. Investors still have to wrestle with asset allocation challenges. While the 4% Rule can help, other factors will impact this decision going forward.
4. The 4% Rule presumes a world economy. Nope, the study is based on U.S. security returns only. This is important because U.S. markets have historically had low volatility and strong returns compared to other countries. International exposure that has become commonplace in portfolios isn’t considered in the study.
5. The 4% Rule is an inflexible dogma. Again, it’s a rule of thumb – a place to begin. It can help in your planning. Still, because the market doesn’t give us straight line returns, there will be times where budgetary surpluses build up. Conversely, if the market doesn’t cooperate, then a person will need to adjust their spending habits years in advance.
6. This 4% Rule has been used for a long time. The original data used in the study traces back to 1926; however, the study was published in 1998 by three professors from Trinity College in Texas. It’s a relatively recent planning standard.
7. The 4% Rule is universally accepted. It most certainly is not. Many economists insist the 4% Rule is not very efficient at all. While they make a compelling case if you dig into it, deep analysis isn’t very useful if no one can understand and apply it. The challenge is giving common investors a principle they can understand and build around. Because of its ease, the rule continues to be one of the better staples of retirement planning.
We hope this helps de-mystify the 4% Rule of thumb for folks. If used correctly, it gives you a goal worth pursuing. Still, it’s important to understand the limitations. If possible, consult a professional to help you work through your retirement plan with the 4% Rule as a reference point. Good luck and remember to stretch before and after you exercise.