Takeaways
- The 4% rule is a proxy for a safe withdraw rate to avoid exhausting retirement funds.
- Reverse engineer how much retirement savings you need to use the 4% rule.
- The 4% rule accounts for inflation and deflation during your retirement years.
- The 4% rule is a barometer for achieving early financial independence.
- Earning an income during retirement can hedge against withdrawing too much.
After building a career and saving for retirement, it is vital to be able to enjoy your golden years. Financial planning early in your career can help you align on how to start saving for retirement and begin saving for the retirement you want.
Once you receive your last regular paycheck, retirement is a balance of enjoying your day-to-day life and not spending too much. One of the most often cited anxieties for retirees is the fear of running out of retirement savings. In a recent survey, 48% of retired Americans believe they will outlast their savings [1]. You can avoid this fear with proper financial planning, consistent savings, and managing retirement spending.
Personal finance experts recommend following the 4% rule when planning how much to spend in retirement.
What is the 4% Rule?
The 4% rule is the amount of money retirees can withdraw from their retirement savings accounts each year, adjusted for inflation, and not exhaust their portfolio. This is known as the safe withdrawal rate.
A landmark study by professors at Trinity University examined how much a retiree could withdraw from their investment portfolio over 30 years and not run out of retirement savings [2]. The study examined various annual withdrawal rates from portfolios consisting of stocks and bonds.
The study also assumed that retirees could increase their withdrawals in alignment with inflation. Therefore, when the cost-of-living increases, retirees can withdraw more funds to keep their standard of living constant. The study concluded that a withdrawal rate of 3-4% would not exhaust your retirement savings over 30 years.
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Dynamic Withdrawals
In the 4% study, retirees could withdraw 4% of their portfolio in the first year. Every year following, the withdrawal rate was a function of 4% and a factor for inflation or deflation. If prices increased 10% annually, you could withdraw 10% more from your portfolio in the second year.
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How Much Will You Need to Retire?
Determining how much you need to save for retirement can be difficult. With the 4% rule in mind, however, you can reverse engineer how much you need to have saved by forecasting the different expenses you will incur once you retire.
How much you spend each year in retirement determines your quality of life. If you want to travel more in retirement, you must account for this in your retirement savings. Creating a budget can be a great starting point.
Consider all the expenses you will need as a 60-70 year old retiree. To get started, here is a non-exhaustive list of expenses to consider when retirement planning:
- Rent or Mortgage
- Groceries
- Healthcare
- Medication
- Transportation
- Travel
- Pets
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Once you have calculated your annual retirement income, you need to determine how large your portfolio needs to be today. Fidelity recommends saving 10X your salary by the time you are 67 years old [3]. For example, if your annual salary is $50,000 when you are 67 years old, you need at least $500,000 saved. This recommendation assumes you want to maintain the same lifestyle throughout retirement.
Salary Multiples For Your Retirement Savings
| Age | Salary |
| 30 | 1X |
| 35 | 2X |
| 40 | 3X |
| 45 | 4X |
| 50 | 6X |
| 55 | 7X |
| 60 | 8X |
| 67 | 10X |
Source: Fidelity Guideline. Save 10X by 67 years old.
Different variables - such as retirement age, geographic location, and lifestyle - affect how much you need to save for retirement. For example, the earlier you retire, the more you need to save. Conversely, the later you retire, the less retirement savings you need.
The 4% Rule in Practice
Let’s look at a practical example of how the 4% rule is applied with a retirement portfolio of $2,000,000. Let’s assume this retirement portfolio has the perfect mix of stock and bonds. The 4% rule advocates that you can withdraw 4% of your portfolio in the first year of retirement. In this example, that would be $80,000.
Every withdrawal after the first year needs to consider inflation. In the second year of retirement, inflation is at 5%. Your safe withdrawal rate allows you to spend about $84,000 (4% x 1.05 x $2,000,000) in year two of retirement (to account for the 5% rise in inflation).
Smart Tip:
Inflation is calculated based on the Consumer Price Index (CPI), which is the average change over time of a pre-specified basket of consumer goods and services [4]. There are specific CPI indexes for geographic regions and the broader U.S. economy.
Your initial income withdrawals might seem generous, but you must remember the 4% rule also considers deflation, or when prices decrease. In the third year of retirement, let’s say the economy experiences deflation at a 3% rate. As a result, you are now only able to withdraw $77,600 (4% x (1-3%) x $2,000,000) to offset deflation.
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Dynamic withdrawals are the key to the 4% rule. Because the goal is to make your portfolio last at least 30 years, modulating your withdrawal amount keeps your spending in line with the economy. Of course, you can adjust your spending based on how the economy is performing and when you get a better sense of your retirement spending.
How to Start Saving for Retirement
With an understanding of how the 4% rule can be used to help plan for how much spending you can enjoy during retirement, and how much you need to save based on your retirement planning, the next step is to start planning on how to get to your savings goal.
If you plan on saving at least $500,000 for retirement but haven’t started putting capital into retirement savings accounts, you need to contemplate how much to start saving to reach your goal. There are many factors to consider, when analyzing how much to start saving for retirement: investment horizon, rate of return, portfolio composition (stocks and bonds), and risk appetite.
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If you are 30 years old and haven’t saved for retirement yet and want to save at least $500,000 by the time you retire, you need to take steps to ensure that happens. Assuming you invest your retirement savings annually at a 7% rate of return for 30 years, you will need to save $441.09 per month to reach your goal.
Based on where you are along your retirement savings journey, you should consider taking advantage of different retirement accounts.
Smart Summary
The 4% rule is a powerful tool to determine how much you can spend each year in retirement. With the end in mind, you can begin calibrating your retirement savings strategy and ensure it aligns with your short-term and long-term financial goals. Saving for retirement can seem like a daunting task at first. The key is to break down your overall savings goal into bite-size pieces and start acting. Creating smart money habits like deferring small amounts of your paycheck to your retirement savings account each month can make the process seamless.
[1] Clever. State of Retirement Finances: 2023 Edition. Last accessed September 6, 2023.
[2] American Association of Individual Investors. Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable. Last accessed September 6, 2023.
[3] Fidelity. How much do I need to retire? Last accessed September 6, 2023.
[4] U.S Bureau of Labor Statistics. Consumer Price Index. Last accessed September 6, 2023.
