Manage Your Monies

What is the Four Percent Rule?

Manage Your Monies

The four percent rule is a great rule of thumb as you plan for your “retirement number”. Not only does your retirement nest egg need to cover your expenses, it also needs to last throughout the rest of your life.

We’ll explain what the 4% rule is, and walk through how it will last throughout your retirement. Finally, we’ll let you know what risks you should keep in mind with this rule as well.

What is the Four Percent Rule?

The 4% rule determines how much you can withdraw from your account once you retire. The goal is to ensure retirees receive a steady stream of income while maintaining their account balance.

Experts consider the 4% withdrawal to be safe, since it will primarily consist of interest and dividends.

For example, if you have $1 million in your retirement account, the maximum you can withdraw per year is $40,000 ($1 million x 4% = $40k).

Multiply by 25 Rule

Another spin on the four percent rule is the multiply by 25 rule. While the 4% rule determines how much you can withdraw once you’re retired, the multiply by 25 rule determines how much you need in order to retire.

The logic is the same. Take the amount of money you need when you retire, and multiply it by 25. If you need $40k per year at retirement, then you’ll need $40k x 25 = $1 million to retire.

If you reverse engineer this and apply the four percent rule, 4% of $1 million is $40k. The math checks out!

“Multiply by 25” is Your Floor

Multiply by 25 is a great aspiration, but keep going once you hit it. That number should be your floor, not your ceiling.

Once you hit that number, keep piling on your savings so you can live a more comfortable retirement. You’re likely in your peak earning years, and the odds of making the same amount of money if you decide to come back to work are low.

If you haven’t hit that number and are wondering how you’re tracking, the Millionaire Next Door has a great formula to use.

The Origin of This Rule

The 4% rule is a result of a Trinity University study from the late 1990s. Using historical data, they found that there was less than a 5% chance of running out of money using the 4% rule.

Here is the math that led them to this:

When Doesn’t the 4% Rule Work?

The 4% rule only works with a reasonable portfolio, such as an investment in the S&P 500 ETF. Warren Buffett claims this is the best investment for most people. For the Trinity Study, the researchers assumed a blend of stocks and bonds. This will lower your average return, but will also make your retirement amount more steady.

If you’re invested in more volatile stocks or assets, you need to lower your withdrawal rate to account for fluctuations. Bonds may also have low returns based due to low interest rates.

Also, this only works if you’re reasonable with your expenses. Make sure to account for your living costs, as well as your future health care costs. If you have a monster mortgage payment and too big of a house, you can downsize if you aren’t able to save more. Your house should not be factored as an investment unless you’re collecting money from rent.

Finally, the last thing you want to do is sell an asset at the market bottom. If the market goes south and takes your good investments down with it, it’s in your benefit to withdraw less so you can take advantage of the low prices. Ideally, you’ll increase your positions during these market downturns.

The Four Percent Rule – The Bottom Line

The 4% rule is a great way to ensure that people withdraw a sustainable amount of money from their retirement account while keeping their nest egg in tact. The last thing you want to do is run out of money in your retirement, and setting a 4% maximum safeguards you from this risk.

With that said, there are some risks to keep in mind. If rates are low, you won’t realistically return 4% from bond investments. Furthermore, you’ll want to lower your withdraw rate if you’re invested in riskier stocks or assets. The last thing you want to do is sell these potential high fliers at the bottom of a market.

Keep this in mind as you save, your retired self will thank you!