"The 4% rule" (aka the Trinity Study) is a common guideline financial planners and do-it-yourself investors use to project how much they need to save by the time they retire. The theory behind the 4% rule is simple, but not flawless. If retirees can expect to earn 6% on a safely allocated retirement account, 2% should be left in the account to keep up with inflation. The remaining 4% can be withdrawn for spending. For a couple who would like to have $7,000 in monthly income, before taxes, from their retirement accounts, they will need $2,100,000 saved before they retire.
The math is the simple part: $7,000 x 12 months = $84,000, $84,000 / 0.04 = $2,100,000 OR $84,000 x 25 = $2,100,000
Predicting accurate inflation levels for decades to come is more complicated. Creating a portfolio that manages the appropriate risk opens the door for further flaws. However, not all flaws are bad. Inflation could be less than 2%, returns could be better than 6%, and the retirees' spending needs may be less than the projected 4% withdrawal. Some flaws are very bad. The US could experience an extended period of hyperinflation with sub-par market performance at the same time that the investor's expenses exceed 4% of the account value.
To hedge some of these risks, fixed expenses should be kept extremely low. All debt (mortgages, cars, credit cards) should be paid off prior to retiring. Nothing should be bought before the retiree has money available to pay for it. Prolonged declines in account values are easier to manage with low fixed expenses. In other words, it's easier to delay a vacation across Europe than it is to delay paying a mortgage or car payment.
The 4% rule is not without its detractors. Some critics believe an annual withdrawal rate of 5-6% has a high probability of allowing retirement funds to last more than 30 years. This difference is based on a higher risk (heavier allocation to stocks) portfolio and unsteady spending. Retirees are likely to have higher spending rates earlier in their retirement, with some of those years incurring higher expenses than others. As they near 80 years of age, most retirees spend much less than they did in their late 60s and early 70s. Therefore, a retiree may be able to withdraw as much as 6% for the first decade of retirement and then will begin to reduce the percentage on a regular basis in future years. In addition, if a longer than expected bear market hits a retiree at the wrong time, he has the option of using a tax-free reverse mortgage to tap into his home equity and avoid selling stocks at reduced prices.
Much of the decision-making on how much to withdraw in the first decade of retirement will be dependent on stock market returns and fixed income yields. If a major bear market hits the portfolio of someone newly retired and the asset allocation was too risky, the next 30 years could be much tighter than it would be if the retiree timed his retirement at the beginning of a bull market. The 4% rule is a good planning step, but those planning for the next 50-60 years should not expect it to be the last financial decision they need to make in retirement.
