The 4% rule is a practical rule of thumb which is used by retirees to find out and know the amount withdrawable from the retirement fund every year. The 4% rule for retirees means accumulating all investments and withdrawing only 4%of the total investments during the initial year and in the following years adjusting the amount you withdraw for inflation.
The main reason to opt for this rule is for getting a steady income on one side and having a balance in the account on the other side for the future. The interests and dividends on savings will add to the account and the account holder can withdraw them.
The 4% Rule
The financial guideline is used by many experts to suggest for those planning for retirement. An estimation is prepared so that a safe and comfortable retirement income is generated.
The health of the investor and the life expectancy are very important factors that will determine the sustainability rate. The investor retirees who are living longer will have to have a long portfolio. The maintenance expenses, medication expenses and other expenses will keep increasing with age.
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Concept of 4% Rule
A financial advisor from South California has attributed the concept of the 4% rule in the midst of the 90s. Later the concept was simplified by the next adherents. He suggested that the 5% rule is more realistic and it relied on the worst case scenario.
The basis of the study was the historical stock data and bond returns. The prime focus was only on the market downfall. Later, over a period of time Bengen gave the conclusion that no historical case existed where 4% of annual withdrawals got exhausted for a retirement portfolio.
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Inflation
Inflation means the rise in the price of general goods and services. Since all the investment amount is used for withdrawal each year the inflation factor will have an effect on the number of withdrawals. Inflation will have a direct effect on the investments and you should be careful about the amount of money you withdraw.
The amount of money you withdraw from the investment should be carefully managed considering the inflation rate. Adjustment of inflation can be done by setting an annual increase of 2% per year or this can also be done by adjusting drawings on the inflation rate. By doing this it will effectively match income to the cost of living.
Pros and Cons of 4% Rule
- When you follow the 4%rule it is more likely that your retirement fund will support you even after you retire from the job. It is important to note that this principle may not be guaranteed as money management is different from person to person.
- It is considered a safe investment strategy where you can protect your future. There are many situations where this principle did not work for many people. It may be because of inflation or because of excess withdrawals from the investments. A situation where the markets are down and this will lead to risk of investment which will affect the returns very quickly.
- The 4% rule may not work if the retiree makes a huge one time purchase because this will reduce the amount of money in investment drastically and thereby the compound interest will get affected.
- Just following the basic principle of money management, if the retiree uses the 4% rule it will definitely have a positive impact and it can provide a steady income. The 4% rule can protect you from the shortage of funds.
Pros
- It is easy to implement and follow
- Providing a steady income and predictable income is possible
- Protection against going out of money during retirement
Cons
- Effect of inflation
- Strict fund management is required
- Will not consider lifestyle changes
Will it work?
The 4% rule is designed to provide financial stability and protection. During the worst financial crisis, this principle would benefit retirees. Since during the retirement age there is no income source generation this principle will help in managing the day to day expenses.
The retiree should be good at money management as excess spending will decrease the fund amount. The financial advisors are suggesting a 5% rule for a comfortable lifestyle but it will depend on various factors and risks are also associated with it.
About the author
Vinay Kumar Goguru is a finance professional with more than 8 years of diverse experience as a researcher, instructor and Industry work experience with both public and private entities. Prior to MyMoneySouq, he spent 6 years in Berkadia, It's a commercial mortgage banking company. He has a "Doctoral Degree in Commerce" and two master's degrees with a specialization in Finance, one as Master of Commerce and other as Master of Business Administration. He has written several articles on personal finance, published by different International journals. He loves traveling, reading and writing is his passion. He has a dream of writing a book on his favorite finance topics.
