The 4% Rule for Retirement Planning

Welcome to Finance Friday.

Last week, we examined how to use compound interest to build a sizeable investment or nest egg for retirement. This week, I want to explore how we can use it for an income.

Living off a Retirement Investment Account

Assuming that you manage to create a sizeable investment account for retirement, as detailed in last week’s newsletter, the most important question now is how much you can take out of this account annually and still be sure that the account lasts for your remaining life. At this stage, your account should be split between safer bonds and more volatile equities, in my opinion.

The 4% Rule

The 4% rule is often used by financial advisors in retirement planning. It is a guide for the safe amount that you can withdraw annually from a retirement account without running out of money over a 30-year period. The rule is based on historical data and assumes a balanced portfolio of stocks and bonds.

You can use the 4% rule to estimate how much money you need in your retirement account when you retire.

6 Steps to Calculate Annual Income in Retirement

• Calculate essential living costs - rent, rates, food, energy, etc

• Do you need a car? If so add motoring costs

• Add an amount for unexpected medical costs

• Add an amount for luxuries necessary to enjoy your retirement - meals out, sports/recreation clubs like golf etc, weekend breaks, annual holidays

• Subtract state pension

• Subtract a company or private pension income

Looking at Some Numbers

The categories we discussed above will vary widely between individuals, towns, and countries.

Figures for an Example Only - Annual numbers

• Essential expenditures - 25,000$

• Motoring costs - 6,000$

• Medical costs (assuming access to National Health Service) - 4,000$

• Luxuries - 10,000$

Total expenditure: 45,000$

• Subtract state pension - 10,000$

• Subtract Private pension income - 10,000$

Total pension income: 20,000$

Contribution from retirement savings = 45,000 - 20,000 = 25,000$

How would you change these figures for your circumstances and your country?

Applying the 4% Rule

We need to calculate the total amount where 4% gives us an annual income of 25,000$

25,000/0.04 = 25,000 × 25 = 625,000$

You can also work out that for every 1,000$ a month (above your pension) you need in retirement, you need 1,000$ × 12 (months) × 25 = 300,000$ in your retirement account.

Problems with the 4% Rule

There are some limitations with the 4% Rule:

• Market Volatility: the 4% rule is based on historical average returns but future returns could be lower or higher. Additionally, if you retire just before a market crash (like in 2008) your nest egg could be depleted quickly.

• Longevity risk: The 4% Rule was based on a 30-year retirement but people are living longer these days. Be careful if you use the 45 Rule for early retirement.

• Inflation: the 4% Rule does not consider inflation so your purchasing power will almost certainly erode over time.

• Lifestyle changes: remember as you go through life your lifestyle may change. You may need to reduce spending on luxuries and increase it on medical expenses, for example.

Please note that I have not taken taxes into account in any of these examples. If you work out your own figures make sure to take tax into account in your country of residence.

Conclusion: The 4% Rule Guideline

My answer to these limitations is that having a retirement nest egg is better than not having one. Do not use the limitations as an excuse not to save.

Additionally, some experts think that you should withdraw less than 4% from your retirement account while others think that you can withdraw more.

My answer is that you should be flexible. For instance, if the markets are strong you can use the 4% rule but in poor economic periods, you may forgo an expensive holiday and withdraw less. In any case, you should only withdraw what you need from your retirement account.

For this reason, I think ‘The 4% Guideline’ is a more appropriate name.

Word of the Day: Nest Egg

Nest egg - noun - an amount of money accumulated as a reserve e.g. for retirement

“Regularly saving a small amount of money is an excellent way to build a nest egg.”

Derived from:

The term nest egg is derived from poultry (chicken) farming.

Nest - noun - a structure built by birds, or insects to lay their eggs or by some animals to live in or raise their young.

Egg - noun - an oval object, often with a hard shell, laid by a female bird, reptile or fish usually containing a developing embryo.

Farmers would place real or fake eggs (also called nest eggs) into a nest in order to encourage hens to lay more eggs and, therefore, increasing the farmer’s income.

Do you have any Business English questions?

Please email me and I will do my best to answer them in future newsletters.

Until Monday - have a great weekend!

Iain.

www.communicateenglish.com

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