Retirees must adjust to the times.
As people move through their careers, it’s common for them to wonder how much they’ll need for retirement. There’s no one-amount-fits-all answer, but luckily, there are rules of thumb people have traditionally followed: The 80% rule and the 4% rule.
The 80% rule deals with how much you’ll need annually, advising people to have 80% of their pre-retirement yearly income in retirement to maintain their lifestyle. If you plan to downgrade your lifestyle, you can lower the percentage, and vice versa.
The thought behind the 4% rule is that retirees could plan to withdraw 4% of their retirement savings yearly for 30 years, adjusting for inflation, without outliving their savings. Unfortunately, it may be time to rethink the 4% rule due to the current economic conditions. Here’s why.
How it traditionally works
If we’re using the 80% rule, here’s how much someone would need annually in retirement based on their current income:
| ANNUAL INCOME | ANNUAL INCOME NEEDED IN RETIREMENT |
|---|---|
| $50,000 | $40,000 |
| $80,000 | $64,000 |
| $100,000 | $80,000 |
| $150,000 | $120,000 |
| $200,000 | $150,000 |
The 4% rule is best used alongside the 80% rule because it tells you the total amount you should aim to have saved for retirement. All you have to do is multiply your ideal yearly income by 25.
| ANNUAL INCOME | ANNUAL INCOME NEEDED IN RETIREMENT | IDEAL TOTAL SAVINGS |
|---|---|---|
| $50,000 | $40,000 | $1 million |
| $80,000 | $64,000 | $1.6 million |
| $100,000 | $80,000 | $2 million |
| $150,000 | $120,000 | $3 million |
| $200,000 | $150,000 | $4 million |
Traditionally, a retiree would withdraw 4% of their savings in the first year and then adjust the withdrawal amount for inflation in the following years. For example, if you had $2 million saved, you would withdraw $80,000 in the first year. If inflation rose by 2% the following year, you’d then withdraw $81,600; if it rose 3% the next year, you’d withdraw $84,048.
Back to the drawing board
Unfortunately, using the 4% rule during these economic conditions — such as inflation not seen in decades and a looming recession — may present a problem. At the end of September, inflation had hit 8.2% year over year. Increasing your withdrawal amount by this much to keep up with inflation could increase the chances of you outliving your savings.
If you withdrew $80,000 in your first year of retirement and then adjusted for the 8.2% inflation rate, you’d withdraw $86,560 in your second year. I don’t have any reason to believe that historically high inflation rates will continue for years, but it’s always better to be overprepared than underprepared, especially with so much economic uncertainty right now.
The creator of the 4% rule, Bill Bengen, even cautioned against using 4% in today’s environment. He told the Wall Street Journal that “the problem is that there’s no precedent for today’s conditions.”
Morningstar recently did a study that suggests retirees should use 3.3% as their initial withdrawal rate. This would give someone with 50% of their portfolio in stocks and 50% in bonds a 90% degree of certainty that they won’t run out of savings over a 30-year span. The higher the degree of uncertainty you’re willing to take on, the closer to 4% you can go.
Adjusting to the times
As with most things in life, it’s all about your ability to be flexible and adjust accordingly. For some people, this will, unfortunately, mean decreasing your yearly withdrawal (especially initially), which could also mean cutting back on your spending and delaying some retirement plans.
It may not be the preferred option, but it beats the alternative of possibly outliving your retirement savings and taking other measures, such as perhaps returning to work. Nobody knows for sure what’ll happen in the coming years, but it’s better to prepare for the worst and hope for the best.
