Cash for life. At what cost?  

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Examining the 4 percent rule

The so-called 4 percent rule has become the popular formula for napkin math when it comes to calculating how long your retirement savings could last. It goes like this: 

  • You withdraw 4 percent from your savings in the first year of retirement.  
  • The balance of your nest egg (the other 96 percent) remains invested, earning 4 percent plus an additional 2 percent to cover the cost of rising prices due to inflation. 
  • As long as the balance grows by at least 4 percent plus the current inflation rate, you should be able to start each new year with a fully restored balance of 100 percent. 

Consider the example below in which a portfolio earns a 4 percent real rate of return and enough to account for 2 percent inflation. The 4 percent is what you withdraw. The 2 percent is added to the portfolio so that it continues to grow slightly every year. Keep in mind, this is an example of the rule. Your rate of return and the actual inflation rate will vary over time. 

Year Account balance Total Investment return of 6% Your 4% withdrawal at end of year
1 $500,000  $30,000  $20,000
2 $510,000  $30,600 $20,400
3 $520,200   $31,212  $20,808
4 $530,604 $31,836   $20,224

 Assumption: Inflation is 2% and real return is 4%. 

And that’s how you make your retirement savings last forever. By applying the 4 percent rule, you accomplish three goals:

  1. An income stream that grows over time because the principal is keeping pace with inflation and rising prices.   
  2. Maintain access to your money in case of an emergency (versus converting it to an annuity).
  3. An estate plan that works in harmony with all your financial strategies to ensure that wealth is transferred to loved ones in the most tax-efficient way. 

The math is solid and the results are encouraging, so what could possibly be wrong with the conventional 4 percent rule? Very little, except that you may end up leaving too much behind. 

Here’s why

If you were able to generate a 4 percent real rate of return, and enough to cover rising prices due to inflation, your savings could be worth as much at age 90 as they are at age 65. 

In his book, The Essential Retirement Guide, Fred Vettese gives an example of the income that a retiree could have withdrawn under the 4 percent rule from 1988 to 2012, with a starting balance of $200,00. Because the portfolio grows slightly each year, the retiree’s income also increases. In this case, income grew from the initial 4 percent of $200,000 ($8,000) to almost triple that amount in 2012 (just under $23,000)1.  

This sounds like a nice problem to have until you add up the lost opportunities along the way. Working with your advisor is the best way to establish a retirement plan based on goals and objectives that allows you to take advantage of every financial opportunity to:

  • Enjoy more of your savings in retirement.
  • Help others while you are alive.
  • Gift money to adult children in time to see the improvement it makes in their lives.
  • Check some destinations off your dream vacation list. 

What’s the answer?

Assuming 3 or 4 percent of your savings would be adequate income in retirement, you have a range of options to discuss with your Lawyers Financial Advisor

Option 1.  Withdraw 4 percent and let your capital grow so that you can confidently ensure there will be money left for your loved ones. 

Option 2.  Strike a balance that lets you withdraw more than 4 percent for the first half of retirement while your health is still good and you can share and enjoy the money. This may include converting the balance of your savings to an annuity around age 80. 

Option 3.  Treat yourself. Spend what you have and hope to achieve a zero-sum result in your final days. This is a tough trick to pull off and not something we would recommend because there is always a risk of outliving your money and you need to budget for potential health care expenses as you age. 

Your napkin math

A coffee and a napkin with your Lawyers Financial Advisor can help you calculate the best way to maximize your retirement savings and explore what your retirement could look like. Have the conversation today to keep your plan on track. 

It is assumed that the account balance was invested 50 percent in equities and 50 percent in bonds the entire time and that annual investment management fees were 1 percent of assets. The Essential Retirement Income Guide, Fred Vettese. 

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