Is the 4% rule right for you?

I had a great chat the other day with a mechanic who came out to help me with my flat battery. We were chatting about various things and he mentioned he was coming up to retirement. He said he had been googling how much money he needed to retire and came across the 4% rule.

He asked me whether that was a good rule to go by and like all things finance, my answer was ‘it depends’.

In this blog post, I thought I might explain what the 4% rule is, where it came from and where and when it may be useful.

What is the 4% rule

The 4% rule is a common rule of thumb in financial planning which says that you can safely withdraw 4% of your savings in your first year of retirement and adjust that amount each year for inflation without running out of money for at least 30 years.

So for example, if you had $1M in your retirement fund, you could safely withdraw $40,000 in your first year and adjust that amount each year for inflation.

This sounds great in theory but in practice, finances rarely work out this way so we will need to explore this further.

Where did the 4% rule come from?

The 4% rule came from Bill Bengen, an American who in 1994 released research relating to safe withdrawal rates.

In his research, Bengen reviewed the historical averages of returns if you had a 50/50 portfolio of US large cap stocks and government bonds and found that with a 4% withdrawal rate, your capital would likely be preserved after 30 years.

So can I rely on the 4% rule

Yes, you certainly can. Will it be accurate on the other hand? Most likely no.

The only thing that is certain about the future is that it is uncertain. What was true in 1994 isn’t true today and most certainly won’t be true into the future.

That being said, at some point, you do need to stop working and start drawing on your investments. If your planned withdrawal is 4% and this can cover your life, then perhaps this is a good starting point to work out your own rules.

There are a couple of things though you might want to consider however.

Do you want to preserve your capital?

Most of our clients spend between $80k to $140k a year when we exclude their mortgage. In order to have a withdrawal rate using the above rule which preserves your capital means you need $2M to $3.5M in investable assets. This is a lot.

Unless you are particularly wealthy, you are likely going to want to spend some of the capital you have saved. Working out your expected life span, your draw down rate and the type of investment returns you expect will allow you to have a more dialled in calculation which will allow you to spend down your capital.

This means you’ll be able to retire earlier and get more of your life back.

Don’t forget about the age pension

When you initially retire, it is possible you may not be eligible for the aged pension as your superannuation may exceed the ‘assets test’. As you spend this down however, you may become eligible which will allow you to top up your super payments from your pension.

Before you retire, understanding when the pension kicks in and how much this will supplement your income will make a big difference to your planning.

Just as an FYI, the aged pension is not a lot of money so I wouldn’t be relying on it solely if you can.

Your investments matter

In the 4% rule, Bengen took into account a portfolio that contained 50% bonds. Prior to 1994, the bond market in the US provided relatively high returns. Since then, as interest rates have moved to zero and even negative, bonds don’t have the same returns they used to have.

You need to consider your own investment strategy which better suits this current economic climate.

So how much money do I need to retire?

I really wish I could give you an easy answer to this question. The allure of the 4% rule is that it is so incredibly simple and allows you to set a point and retire with confidence. But this isn’t how it works in practice.

If you’re looking to retire and are unsure how much money you need, please reach out. As part of any advice, we would run scenarios taking into account your personal situation (assets, debt, age etc). This is never going to be 100% accurate (as we are trying to predict the future), but it will hopefully give you some level of understanding of what different retirement dates look like.

After all, if working another 6 months meant that you wouldn’t run out of money in retirement, would you do it? I know I would.