Finding Your Own 4% Rule (2 min. read)

By Andy Meyer, Vantage Financial Partner & Senior Wealth Advisor

It’s human nature to look for short-cuts or ways to simplify a problem or question.

We all do it. Whether it’s when we cook, try to lose weight, or grow our net worth.

For decades, the 4% rule has been used as the way to simplify retirement and answer the question, “How much money do I need to retire?”

Overall, it’s not a bad place to start. For a lot of Midwesterners, 4% should get the job done, or come close.

BUT this old rule of thumb should not be a crutch or a way to shortcut your way through retirement planning. Especially if retirement is still a ways away.

There are too many variables and potential “worst-case scenarios” that could blow up a retirement plan built solely off the 4% rule.

First, a quick review of the rule:

The “4% rule” is a frequently used barometer for retirement spending. It has been around 30 years. You can simply add up all your investments and take 4% of that total. That is your retirement income in year 1. For years 2 through 30 you should, at the very least, factor in some sort of inflation. Whether its 4% of the total + 2% inflation or less, inflation needs to have a say in future spending.

Whether you use 2% or 4% for inflation, your unique spending history should determine the range of inflation used in your projections.

This is where we all need to take an honest look in the mirror while being realistic about future spending habits.

  • Have your expenses gone up over the years simply because your income has?
    • Fixed or variable expenses? Or both?
  • Has your savings rate consistently increased over the years?
    • If so, by how much? If not, is it because of the first question (life-style creep)?
  • Is your balance sheet improving?
    • Think more equity vs more debt.

Future inflation is no guarantee – that’s for another blog post – but creating room for some margin of error is important. Therefore, we run Monte Carlo simulations and hundreds of different variables when stress testing longer term projections. The stretch goal should be that it takes real effort to make your future financial state look bad.

The 4% rule is a great place to start, but there are reasons why it doesn’t fit every person’s situation.

It’s rigid, and assumes you increase your spending every year by the rate of inflation. This is not how most people spend, especially in retirement – expenses change from one year to the next and will likely fluctuate throughout retirement, well beyond or well below the rate of inflation. Some people have room in their budget to decrease spending during volatile economic times. Others do not, and this goes to looking in the mirror to factor in your unique spending style.

Furthermore, the 4% rule does not factor in portfolio performance; the rule applies to a hypothetical portfolio comprised of 50% stocks and 50% bonds. Most portfolios are more broadly diversified across asset classes, and most people will adjust their investments throughout the course of their retirement in one way or another. Real life portfolios consist of real estate, inheritance, insurances, and partnerships. These different asset classes will likely perform differently during various time periods. In the last 24 months we saw the barrel price of oil go from being NEGATIVE to $100+. In the last decade, we witnessed the housing market go from crashing to a slow rebound, to a rip-roaring rally of endless all-time highs. And this year! We have had one of the worst starts to a year for a 60/40 portfolio in the last 5 decades + the worst start for bonds in history! The list could go on. But if you retired this year, last year, or are preparing to retire in the next couple of years, you are experiencing a much different investment/performance environment than if you retired three or five years ago.

The 4% rule may smooth some of these factors out, but it may also miss a key variable or two that could directly affect your plan.

A personal analysis of your financial plan from year to year is key to enjoying confidence and security for many seasons to come. We are happy to provide the calculations and a proper review of your assets and strategy for retirement.

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