The 4% rule is a common rule of thumb in retirement planning to help you avoid running out of money in your later years.
But the question is, how relevant is it in the economic world we live in today? Let's take a deep dive into the pros and cons of the 4% rule to see if it works for you.
What do we mean by the 4% rule?
The 4% rule states that you can comfortably withdraw 4% of your total investments 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, but as with all personal finance matters, 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 surplus that you could have spent on the things you enjoy.
In addition, Australian tax rules requiring minimum super withdrawal rates can pose a barrier to applying the 4% rule across your entire financial profile, including your savings accounts and super account.
When should you use this approach?
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, be aware that the 4% rule was created as a general guideline in 1994 by financial adviser William Bengen. The world we live in is a vastly different place now, so following it does not guarantee that you will have enough retirement funds to last the distance.
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 that 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.
Additionally, 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 their retirement. They often devote more time to hobbies or travel, and their spending is often higher. Spending then typically falls in the middle part of retirement before rising again due to greater healthcare expenditure later in life.
The 4% rule is not 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 some advantages and disadvantages. The pros include:
- The rule is simple to follow
- You'll have predictable income
- Traditionally, the 4% rule was designed to protect retirees from running short of funds.
Some of the cons are:
- It isn't dynamic enough to respond to lifestyle changes
- The 4% rule doesn't react to different market conditions
- It is somewhat outdated now and can no longer guarantee that your funds 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).1
Superannuation income streams provide a way to receive regular payments from your super fund to 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 challenging to apply. The minimum payment levels may even exceed your needs in a given year.
The benefits of advice
Clearly, cookie-cutter strategies are complicated to use in 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 provide personal advice, always read their Financial Services Guide first, explaining how they charge fees and any links they have to companies providing financial products.
Try to choose a fee-only financial advisor instead of an advisor who is paid on commissions. Although it might cost you a small amount upfront, 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 several 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 it also assumes a rigid investment portfolio mix of 60% shares and 40% bonds, which 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.