What is the 4% rule?

What is the 4% rule?

The 4% rule is a common rule of thumb in retirement planning to help you avoid running out of money in retirement. It states that you can comfortably withdraw 4% of your savings in your first year of retirement and adjust that amount for inflation for every subsequent year without risking running out of money for at least 30 years. 

It sounds great in theory, and it may work in practice for some who have their own savings set aside. But like all personal finance, there's no single answer that works for everyone. 

Blindly following a formula without considering whether it's right for your situation could lead you to either run out of money prematurely or be left with a financial surplus that you could have spent on things you enjoy. 

In addition, Australian tax rules requiring minimum super withdrawal rates can pose a barrier to applying the 4% rule.

When should you use the 4% rule?

The 4% rule assumes your investment portfolio contains about 60% shares and 40% bonds. It also assumes you'll keep your current spending level throughout retirement. If both of these things are true for you and you want to follow the simplest possible retirement withdrawal strategy, the 4% rule may be right for you.

However, you should be aware that the 4% rule is an older rule. Following it no longer necessarily guarantees you won't run short of funds. It may work depending on how your investments perform, but you can't count on it being a sure thing because it was developed when bond interest rates were much higher than they are now.


When the 4% rule may be the wrong choice

If you want to be 100% sure you won't run out of money, following the 4% rule likely isn't the best choice. Not only is it an older rule, but it also doesn't account for changing market conditions. 

In a recession, it's probably not wise to step up your withdrawal amounts. You may even want to reduce them slightly. But when the markets are doing well, you might be able to withdraw more than 4% comfortably.

If you've chosen an asset allocation other than 60% shares and 40% bonds, you should also avoid following the 4% rule, because this is the asset mix the rule was based on. 

When you invest in a different mix of assets, your portfolio will produce different average returns over time. For example, investing more in bonds could result in slower investment growth because bonds typically offer lower returns than shares. 

This problem is exacerbated by the fact that when the 4% rule was developed, bond interest rates were much higher than they are today.

Finally, if you're expecting your spending patterns to change throughout retirement, the 4% rule isn't the best approach. 

Most retirees are more active in the early part of retirement. They often devote more time to hobbies or travel, and their spending is often higher. Spending then falls in the middle part of retirement, before rising again due to costly healthcare expenditures late in life. The 4% rule isn't dynamic enough to account for these lifestyle changes. It limits you to a set amount, which may be too little in your early years and too much in your later years.


What are some pros and cons of the 4% rule?

The 4% rule has advantages and disadvantages.

Pros Cons
The rule is simple to follow It isn't dynamic enough to respond to lifestyle changes
You'll have predictable, steady income The 4% rule doesn't respond to market conditions
Traditionally, the 4% rule protected you from running short of funds

It is outdated, and following it may no longer guarantee your account won't run short


Does the 4% rule work for you?

One barrier to applying the 4% rule in Australia is the rule on minimum withdrawal amounts for account-based super income streams imposed by the Australian Tax Office (ATO). 

Superannuation income streams provide a way to receive regular payments from your superannuation fund which can help you manage your income and spending when you retire. They are often called pensions or annuities. 

However, under ATO rules, account-based payment streams can have minimum and maximum amounts to be paid in a given financial year. 

The minimum rates typically start at 4% and increase as you get older. The exact amounts were temporarily reduced in response to the COVID-19 pandemic, but the fact that most of the minimum rates usually sit above 4% makes the 4% rule difficult to apply. The minimum payment levels may even exceed your needs in a given year.

Clearly, cookie-cutter strategies are very difficult to apply to retirement planning. Instead, it makes sense to talk to a financial advisor about your vision for retirement and how that will affect your spending habits. An advisor will help you determine how much you need to save and develop a plan for how much you can comfortably spend each year to avoid running out of money too soon. 

In Australia, there are strict requirements on who can provide financial advice. An advisor giving advice on investment products must be authorised under an Australian financial services (AFS) licence. 

If they are providing personal advice, always read their Financial Services Guide first, which will explain how they charge fees and any links they have to companies providing financial products. 

Try to choose a fee-only financial advisor. Although it might cost you a small amount up front, financial advisors who earn commissions when you buy certain investments can make recommendations based on their best interests, rather than yours.


Foolish bottom line

While the 4% rule provides a simple approach to determining how much to withdraw each year from your retirement accounts, it has a number of limitations and can’t guarantee your money will last through your retirement. 

The rule is based on outdated assumptions about the interest you'll likely earn from investing in bonds and assumes a rigid mix of shares and bonds that may not work for some people. 

Instead, it’s a good idea to invest some time in developing a personalised withdrawal strategy that fits within the superannuation rules and is tailored to you. 

Your needs and goals in your later years are dynamic, and you need a withdrawal plan that is dynamic, too.

The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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