Retirement Rules of Thumb: The 4% Rule and More21st December 2015
Building sufficient wealth during your working years is challenging enough, but retirement planning does not stop when the accumulation phase is over. The decisions you need to make in retirement are no less important and no less complex. The objective is clear: You want to enjoy retirement income as high as possible, but not run out of money before you die.
There are no universal rules how to achieve that goal, as people differ in the size of their pension pots, cost of living, family situation and other unique circumstances. However, there are a few “rules of thumb” which you can use as a starting point or as an anchor to keep your expectations realistic and to avoid making fatal mistakes.
The 4 Percent Rule
This is probably the best known retirement rule: If you only spend 4% of your retirement pot in any individual year, it is highly unlikely that you will run out of cash before you die.
Assuming that you retire at 65 and there is zero return on your investments, taking out 4% (1/25) every year will make your pension pot last 25 years – until the age of 90. In reality there are a number of variables complicating the equation. For example:
- You don’t know how long you will live. As life expectancy generally increases, many people will live well beyond 90. In fact, your own life expectancy rises with every year you have survived. When you are 85, the probability that you will reach 90 is much higher than it was at the age of 65.
- Inflation is unpredictable. Even if prices remain constant (they won’t), your own spending needs will change over time. In the early years you may spend more on travel and other interests. In the later years your hobbies may cost less, but you may need more expensive care.
- The return on your investments will most likely be above zero, making your retirement pot last a bit longer. However, it is uncertain and can be very volatile (even negative) in the short run. Most people prefer to make their investment portfolio more conservative as they age, which will also affect performance.
For these and other reasons, there is no one-size-fits-all rule. 4% is not a magic number but a rough guidance. For some individuals it can be perfectly rational to spend 5%, while others may want to err on the cautious side and spend much less. The point is that it’s not realistic to spend 10% or more every year and expect your pension pot to last for 30 years.
Your strategy should be regularly adjusted, to make sure it reflects changing circumstances in both the financial markets and in your own life. Reviews don’t necessarily mean radical changes – just staying in control and knowing what you can afford at any time.
Annuitize to Secure Basic Income
Ideally, basic living costs such as housing, utilities, groceries and healthcare should be covered by guaranteed, permanent and inflation-protected income. In other words, you need to be able to pay your bills regardless of the stock market and even if you end up living much longer than expected. Unfortunately, the typical sources of guaranteed income – State Pension and defined benefit pension schemes – are insufficient and not available to all.
You may want to buy an annuity to cover the essentials forever. Although it’s not always necessary to do so as soon as you retire, you should not postpone this decision for too long. At some point your health may deteriorate and you may lack the intellectual capacity to understand the risk/reward trade offs of drawdown in late old age. The rule of thumb is to have secured guaranteed income by the age of 75, but like the 4% rule it’s rather a rough guidance.Share: