When you have a bad day at work, it’s common to ask yourself, “How much does a person need to retire?”
I’ve been there, grinding it out and dreaming of the days I can ignore my emails and enjoy a good book with a margarita on the beach.
Planning for retirement can be complex, but when I came across the 4% rule, it just made sense as an easy tool to quickly establish how much income we’ll each need to retire.
What is the 4% Rule?
The 4% Rule is a guideline used in retirement planning to help determine the amount of money a retiree can safely withdraw from their investment portfolio each year without running out of money during their retirement. Introduced by financial planner William Bengen in the 1990s, the 4% rule is based on historical market data and portfolio simulations.
According to the 4% Rule, a retiree can withdraw 4% of their initial portfolio balance in the first year of retirement and adjust that amount for inflation each subsequent year. So, for example, if you have a $1,000,000 portfolio, you can withdraw $40,000 in the first year and then increase that amount each year to account for inflation.
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Answering the question, “How much does a person need to retire?”
Many factors can influence the amount you’ll need to retire. The simplest answer is to use the amount of income you need now and then multiply that number by 25.
So, if you need $50,000 a year to live off of now, multiply that number by 25, and you get $1,250,000 as the amount you need to retire.
Here’s a more detailed explanation of how you can use the 4% rule to figure out how much you need saved to retire:
Step 1: Estimate your annual retirement expenses
You’ll need a rough idea of how much you’ll spend each year in retirement. This can include expenses such as housing, healthcare, food, transportation, and leisure activities. This number may differ from your current expenses, as some expenses may decrease (e.g., no longer commuting to work) while others may increase (e.g., healthcare costs).
As a general rule, if you want to maintain your current lifestyle, you can use your current yearly expenses. However, if you think you’ll live more simply in retirement, you can decrease the amount you spend each year, or if you want to inflate your lifestyle, you can increase the amount you spend each year to get a good gauge of how much you’ll need each year in retirement.
For example, we’ll say our retirement expenses will be about $60,000 annually.
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Step 2: Determine your desired retirement income
Once you estimate your annual retirement expenses, you can determine how much annual retirement income you’ll need to cover those expenses. For example, if you expect to get social security or a pension, you can subtract that amount from your yearly expenses to determine how much income you’ll need each year in retirement.
For example, we’ll expect $10,000 in social security benefits annually. So if we take $60,000 from above and subtract $10,000, we determine that we need $50,000 of income each year in retirement.
Step 3: Multiply your desired retirement income by 25
The 4% rule suggests that you’ll need to have 25 times your desired annual retirement income saved to safely withdraw 4% of your initial retirement portfolio balance each year. So, if you want $50,000 in annual retirement income, you’ll need to have $1.25 million saved ($50,000 x 25).
Here’s what it looks like in practice
I don’t know about you, but I’m a visual learner. Here’s how it would look in the first 10 years of retirement. In this example, the retiree starts withdrawing $40,000 in the first year. Each year, the withdrawal amount is adjusted for inflation by 3%. The portfolio grows at an average rate of 7% per year (the average inflation-adjusted return of the S&P 500). At the end of 10 years, the retiree has withdrawn $464,530, and the portfolio value has increased to $1,309,437.
| Year | Portfolio Start | Withdrawal | Inflation Adjusted Withdrawal | Investment Returns | Portfolio End |
| 1 | $1,000,000 | $40,000 | $40,000 | $67,200 | $1,027,200 |
| 2 | $1,027,200 | $40,000 | $41,200 | $69,104 | $1,055,104 |
| 3 | $1,055,104 | $41,200 | $42,436 | $71,088 | $1,083,756 |
| 4 | $1,083,756 | $42,436 | $43,709 | $73,157 | $1,113,204 |
| 5 | $1,113,204 | $43,709 | $45,020 | $75,313 | $1,143,498 |
| 6 | $1,143,498 | $45,020 | $46,370 | $77,558 | $1,174,686 |
| 7 | $1,174,686 | $46,370 | $47,761 | $79,897 | $1,206,822 |
| 8 | $1,206,822 | $47,761 | $49,194 | $82,329 | $1,239,957 |
| 9 | $1,239,957 | $49,194 | $50,670 | $84,857 | $1,274,144 |
| 10 | $1,274,144 | $50,670 | $52,190 | $87,483 | $1,309,437 |
The Caveats
It’s important to note that the 4% Rule is a guideline, not a guarantee. The 4% rule doesn’t consider changes in market conditions (see the sequence of returns risk below), unexpected expenses, or changes in your circumstances. Therefore, it’s important to review your retirement savings plan regularly and adjust your withdrawal rate and investment strategy to ensure you’re on track to meet your retirement income goals.
Sequence of Returns Risk
Sequence of returns risk refers to the danger that the timing of withdrawals from a retirement account will negatively impact the overall rate of return available long term. For example, if the market experiences a downturn early in retirement, and you are withdrawing at the 4% rate, the portfolio may be depleted more quickly than if the negative returns occurred later in retirement. This is because early withdrawals are made when the portfolio’s value is lower, so a larger percentage of the portfolio is sold. Basically, if/when the market then rebounds, there is less of a “nest egg” in the account to benefit from the upswing.
While the thought of this is scary, a couple of options to help with this problem is to use a more conservative withdrawal rate (like 3%) and/or to have an emergency fund of cash available so you can avoid taking money out of the market if there’s a downturn. Diversification is also helpful. If one asset class is down, perhaps you can use another one that’s up.
All this being said, make sure you consult a financial professional and do your due diligence before making significant decisions about your retirement strategy.
Frequently Asked Questions
Here are some of the most frequently asked questions about the 4% rule.
How does the portfolio value continue to go up?
If you looked at the example above and the portfolio value continuing to go up has you scratching your head, you’re not alone. It continues to increase because the investment returns generated by the assets in the portfolio (stocks and bonds) are greater than the withdrawals made by the retiree. In the given example, the portfolio generates a 7% average annual return, while the withdrawals start at 4% of the initial portfolio value and increase by 3% each year to account for inflation.
When the investment returns consistently outpace the withdrawals, the portfolio can continue to grow over time. However, it’s important to remember that the simplified example assumes a constant 7% return every year, which is unrealistic, as investment returns can fluctuate significantly from year to year.
In real-world scenarios, there may be years when the portfolio value decreases due to market downturns or other factors. However, the 4% Rule was designed to provide a relatively safe withdrawal rate that allows the portfolio to last for at least 30 years under most historical market conditions. Remember that the 4% Rule is a guideline, and individual circumstances, market conditions, and investment performance can all impact the actual results.
What happens if the market does poorly?
If the market performs poorly, it can significantly impact the sustainability of a retirement portfolio, especially if the poor performance occurs during the early years of retirement. In such a scenario, the value of the investments in the retiree’s portfolio could decrease, making it more challenging to maintain the desired withdrawal rate without depleting the portfolio more rapidly than anticipated.
Here are a few potential outcomes and considerations if the market performs poorly:
- Reduced Portfolio Value: If the investment returns are lower than expected or negative, the portfolio value will decline, reducing the available funds for future withdrawals.
- Increased Sequence of Returns Risk: When poor market performance occurs during the early years of retirement, it can have a compounding effect on the portfolio’s longevity. This is known as sequence of returns risk. When you’re forced to withdraw money from a shrinking portfolio, you may not have enough time to recover before you deplete your assets.
- Reevaluate Withdrawal Rate: In response to poor market performance, you may need to reevaluate your withdrawal rate and reduce it to preserve the portfolio’s longevity. This could involve cutting back on discretionary expenses or finding additional sources of income.
- Rebalance Portfolio: It’s essential to periodically rebalance your portfolio to maintain your desired asset allocation. This helps manage risk and can potentially take advantage of market opportunities when certain assets are undervalued.
- Maintain a Cash Reserve or Emergency Fund: A cash reserve or emergency fund can help you avoid selling investments at a loss during market downturns. You can use these funds to cover living expenses until the market recovers.
It’s crucial to have a well-thought-out retirement plan that accounts for potential market fluctuations and incorporates risk management strategies. Consulting with a financial professional can help you develop a plan tailored to your specific needs and risk tolerance.
What happens if the market does well?
If the market performs well and your portfolio grows more than anticipated, you may have the flexibility to increase your withdrawal rate. However, it’s essential to approach this decision cautiously to ensure you maintain the long-term sustainability of your retirement funds.
Here are some considerations if you’re thinking about increasing your withdrawals when the market does well:
- Reevaluate your financial goals: Before increasing your withdrawal rate, review your financial goals and needs. Consider whether you have new expenses, plans, or desires that justify the increased withdrawal, and make sure the additional withdrawals align with your long-term goals.
- Assess the sustainability of the increased withdrawal rate: Work with a financial professional to evaluate the impact of the higher withdrawal rate on the long-term viability of your portfolio. The analysis should consider factors such as market conditions, inflation, and your life expectancy.
- Consider a dynamic withdrawal strategy: Rather than strictly adhering to the 4% Rule, you might consider using a dynamic withdrawal strategy that allows for adjustments to your withdrawal rate based on market performance and other factors. For example, you could use a “guardrails” approach, increasing your withdrawal rate when your portfolio outperforms expectations and decreasing it when the market performs poorly.
- Maintain a conservative approach: It’s generally a good idea to err on the side of caution when it comes to retirement withdrawals, as the future is uncertain. Even if the market is performing well, preparing for potential downturns or unexpected expenses is crucial.
- Reinvest surplus funds: If your portfolio grows significantly due to strong market performance, you may consider reinvesting some surplus funds to further grow your assets and provide a buffer against future market volatility.
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P.S. The information provided on this blog is for educational and entertainment purposes only. It should not be construed as financial advice. The content is not intended to be a substitute for professional financial advice. You should always consult with a qualified financial advisor or other professional before making any financial decisions. The author and publisher of this blog make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability with respect to the blog or the information, products, services, or related graphics contained.
