Wondering how much you need to save for retirement?
The math isn’t exactly rocket science. But you do need to understand the concept of safe withdrawal rates to run the numbers.
Here’s a quick overview, along with a withdrawal rate in retirement calculator to run numbers quickly.
What Are Safe Withdrawal Rates for Retirement?
While safe withdrawal rates sound complicated, they’re actually pretty simple.
A safe withdrawal rate is what percentage of your retirement portfolio you can pull out every year to live on, without running out of money before you croak (called “superannuation” by finance nerds). The more you pull out every year, the faster you’ll burn through your money. Not exactly rocket science, right?
So, one question is how long you want your nest egg to last. If you only plan on living for ten years after retiring, then you can burn through your nest egg much faster than someone who wants it to last for 30 years, or 50 years, or indefinitely.
Which brings us to the classic safe withdrawal rate that you may already be familiar with: the 4% Rule of retirement planning.
The 4% Rule in Retirement
Rewind to the ’90s when a financial planner named Bill Bengen ran an interesting study: he analyzed stock market data from the previous 75 years and found that if retirees withdraw 4.2% of their nest egg each year, mathematically their savings is nearly certain to outlive them. This became simplified to the 4% Rule: retirees can pull out 4% of their savings each year to live on, and their savings should last at least 30 years.
Imagine the first year of your retirement earns an average historical stock market return of 10%. You pull out 4%, so your portfolio still sees a 6% rise in value.
In this average-year example, your portfolio still rises in value by 6%! You can live forever on that nest egg, right?
On paper, yes. The problem is the stock market doesn’t rise by a uniform 10% each year: it drops by 23% one year, surges by 35% another year, and wobbles its way upward by 8% the next year. This volatility poses a threat called sequence risk — the risk that the stock market will crash within your first 5-10 years of retirement, depleting your portfolio to the point that it can’t recover, even after stocks bounce back up again.
Fortunately, you have plenty of options for mitigating sequence risk. They share one thing in common: they’re all income-producing investments that don’t require you to sell off stocks in order to pay your bills. Options include rental properties (more on that shortly), dividend-paying stocks, bonds, private notes, real estate crowdfunding investments, REITs, and any other income-producing assets.
How Inflation Impacts Safe Withdrawal Rates
“Whoa there, what about inflation? That $40,000 won’t be worth as much in ten years from now!”
The 4% withdrawal rate applies to the first year of retirement. After that, you simply adjust the annual withdrawals to keep pace with the higher cost of living.
Let’s say Heidi wants $40,000 each year in retirement income. She plans on following the 4% Rule in retirement. So, she divides 100% / 4% and reaches a multiplier of 25. She then just multiplies $40,000 by 25 to reach a target nest egg of $1,000,000.
She reaches her goal of $1 million, retires, and withdraws $40,000 in her first year of retirement.
In her second year of retirement, the inflation rate is 2%, so she adds 2% to her annual withdrawals. Instead of pulling out $40,000 in Year 2, she pulls out $40,800. In Year 3, the rate of inflation hits 3%, so she tacks on another 3% to her previous year’s withdrawals. That puts her annual withdrawal at $42,024. And so it goes, as she adjusts her withdrawals for higher living expenses based on the annual rate of inflation.
Meanwhile her stock portfolio continues to grow — at least when the market rises. Maybe the stock market crashed 18%. Or maybe it surged 26%. But over time, she pulls out far less than the average market return, which is why the 4% rule of thumb works.
Does the 4% Rule Hold Up in Today’s Economy?
Bengen ran his analysis back in the ‘90s. You may have noticed that a few things have changed in the economy since then — particularly interest rates being held low for basically this whole century to date.
That begs a few questions, such as:
“Does this 4% Rule even guarantee me those 30 years? It sounds like I could run out even before then!”
“What if I want to retire young? What if I want my nest egg to last 50 years, not 30 years?”
Excellent questions. First, you can take comfort in the fact that over the last 150 years, there has not been a single 30-year stretch when someone following the 4% Rule would have run out of money in under 30 years. Financial planner Michael Kitces ran those numbers, not me — rest at ease.
Kitces also calculated that you don’t have to reduce your withdrawal rate by much, in order to make your nest egg last forever rather than just a minimum of 30 years. Instead of following the 4% Rule for retirement planning, just set your initial withdrawal rate at 3.5%. Based on historical data, your portfolio should continue rising forever, because you’re withdrawing so much less than the returns.