Don’t cheat yourself with the 4% rule

If you’re planning for retirement, you’re probably thinking about how much you’ll need, how long the money will last, and how much you can safely take out each year.

You recognize that in retirement there will be a balancing act between spending on current needs while also preserving enough for your later years. You might say, “Sure, I’d like to leave something to the kids. But first I want to make sure we’re comfortable.” Or, if you have a sense of humor, with a wink and smile you might say “I plan to let the last check bounce!”

That may be what people who are nearing retirement say, but research shows it’s not what they do. Instead, all-too-often, retirees use simplified rules of thumb to determine how much to take out each year. The result is their assets continue to increase in retirement, and this increased wealth is passed along to beneficiaries. There’s nothing wrong with passing along more, of course. But what if there was a way to enjoy more of what you’ve accumulated along the way? Not spending more just for the sake of spending, but using funds to spend more time with family and help those you care about while you are around to enjoy the impact of doing so. There is a way to do this while still preserving enough for your later years, but it doesn’t happen by following a rule of thumb.

Take the popularized “4% rule” as an example. It’s a rule of thumb that says you can withdraw 4% of your portfolio value each year in retirement without incurring a substantial risk of running out of money. Using this rule, for every $100,000 you have, you’d withdraw $4,000 a year. This rule is based on solid academic research. That’s great. We all like historical research, particularly when it comes to serious topics like making sure you don’t outlive your savings. But the research used a “set it and forget it” approach — it did not account for the ability to adjust behavior along the way. In other words, basing your retirement withdrawals on such a rule is like planning your finances based on your situation at age 25, and then never again adjusting the plan.

Read: It’s harder than you think to spend down your 401(k) in retirement

Unless we see the return of a Great Depression era, followers of the 4% rule “will most commonly just leave a huge amount of money left over,” says Michael Kitces in his research piece, entitled “How Has The 4% Rule Held Up Since The Tech Bubble And The 2008 Financial Crisis?”

In addition to being incredibly conservative, the 4% rule does not consider other sources of income you have and the timing of when each source begins. For example, some may retire at age 60, but not have access to Social Security or a pension until a few years later. Why scrimp by only withdrawing 4% of your portfolio while waiting for Social Security? It often makes more sense to withdraw more than 4% during that window of time — yet many retirees won’t do this because the popularized rule of thumb has made them fearful that they’ll run out of money if they don’t follow the rule each year. In fact, when done properly, often the opposite is true. Customized withdrawal plans increase the odds your savings will last longer.

Money is a tool we can use, and we can’t take it with us. It allows us to contribute to family, to education, to causes and communities that matter to us. Instead of using a “set it and forget it” strategy that forces you to live like you’re in a recession from day one of retirement, you can build a flexible approach. Then you use a set of diagnostics to determine when to make changes.

Just like engineers follow defined formulas to build bridges that we feel safe driving across, there are mathematical concepts that can be applied to test your retirement income plan each year so you feel safe it will continue to work.

Such testing includes things like a Monte Carlo analysis, a way to simulate random future market conditions, calculating your minimum required return that it takes to make your plan work through life expectancy, and using present value formulas to compare your scheduled future withdrawals to what you have now.

If you haven’t heard of these concepts, that’s understandable. Much of the financial industry still focuses on investment products and simplified rules. That makes perfect sense. It’s hard to condense years’ worth of studying, research and experience into a single consumer article. It’s much easier to write about a rule of thumb or sensationalize the latest stock market gyration.

If you like the concept of a dynamic withdrawal plan but aren’t comfortable implementing it yourself, you can hire a professional. You have to know what to look for though. Retirement income professionals use defined formulas, such as those taught in the Retirement Management Advisor courses offered by the Investments & Wealth Institute.

Be cautious of a financial adviser who uses a rule of thumb to determine your retirement withdrawal amounts. There is nothing unprofessional about using a rule of thumb to set broad, general expectations. But when you are at the point where you will begin withdrawals in the next few years, it’s time to throw out generalizations. Retirement is the biggest financial decision you’ll make and you need a customized plan, not a rule of thumb.

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