See how well you're prepared to retire with the 4% rule
Whether you're planning to retire next year or 25 years from now, you need to put the 4% rule to work.
It's one of the best ways to tell how much monthly income you can generate from a $50,000, $100,000 or $500,000 nest egg without having to worry about outliving your money.
Officially known as the "Four Percent Drawdown Rule," it says that you start by taking out 4.5% of your savings the year after you stop working, then withdraw the same amount, adjusted for inflation, each year after that.
(Yes, it seems like it should be called the 4.5% rule, but what can we say? The 4% rule is the name that stuck.)
If you do this, the rule says your savings should last through at least 30 years of retirement.
There's been some debate about whether we can still count on that with volatile stock markets, record-low interest rates and a lot of uncertainty over inflation making it harder to earn a respectable return on our savings.
Perhaps we should plan to withdraw no more than 4% plus inflation? Or even 3.5% or 3%, they suggest.
But after a lot of calculating and soul searching, most advisers seem to be sticking with the original rule as a good starting point for planning and discussions.
"It puts things on a simple level that is easy for people to understand," says Mari Adam, a financial adviser in Boca Raton, Fla. "Some people could take out more, some less. There is no perfect number. But it's a fair percentage."
One reason we like the rule is that it's really simple to use.
Let's say you plan to have $500,000 in stocks, bonds and CDs when you stop working.
That establishes a base for your withdrawals of $22,500 for your first year as a retiree to cover your living expenses.
If inflation ran in line with the historical average of 3% for each of the next two years, you'd withdraw $23,175 in the second year and $23,870 in the third year.
Your balance will slowly fall, but retirees who have followed the 4% rule have typically seen their savings last about 30 years.
The 4% rule was created in 1993 by Bill Bengen, a certified financial planner and author in Chula Vista, Calif.
He looked back through history to see how various retirees on various dates from 1926 through the 1980s had done had they invested in a balanced portfolio of stocks, bonds and cash.
"I tried to find the worst-case scenario where retirees ran out of money [in less than 30 years], and the rate was about 4.5%," Bengen says.
But a lot has changed in the financial world since Bengen did those calculations, and some pessimistic money managers question whether investors can count on the next 60 years playing out as well as the 60 years he studied.
It's possible to come up with an almost endless number of scenarios, from runaway inflation to another global recession or banking crisis that could wreck returns and cause retirement funds to drain away more quickly.
"I haven't seen evidence yet that the 4% rule will be violated," Bengen says. "But no one knows for sure. No one knows what inflation will be in the future and if we're entering a period of [lower] returns."
Those who want to be a little safer in their planning could use a lower withdrawal rate — assuming you can do that and maintain your standard of living.
Most financial advisers say you've got to be able to replace 70% of your pre-retirement income to be safe and secure during your later years.
So, let's assume you and your spouse make $70,000 a year, or about $5,800 a month, and want to generate 70% of your current income after you retire.
That works out to about $4,100 a month. (Replacement income calculations are almost always done on a monthly basis.)
The Social Security Administration can provide an online estimate of what your monthly benefits will be based on current law.
For this example, let's assume you and your spouse will each receive the average monthly Social Security retirement benefit of $1,269 (as of July 2013).
That $2,538 per month puts you more than halfway to your goal.
If you don't have any other sources of income to depend on, you'd need to generate the remaining $1,562 per month from your savings.
Using the 4% rule, that means you'd need about $467,400 in savings to safely draw that much each month.
(Here's how to do the math: Multiply the monthly income you need from your savings by 12 and divide the product by 0.04. So $1,670 a month times 12 is $18,696; divided by 0.04, it's $467,400.)
Now if you're feeling uncertain about the future and think inflation could be higher and returns could be lower, then use 3.5% or 3%.
At 3.5%, you'd need $535,542 to maintain that standard of living. At 3%, you'd need $624,800.
Don't be discouraged if those calculators say you'd need to set aside more from your paycheck than you can possibly afford.
Save what you can. It isn't an all-or-nothing proposition.
If you build a nest egg of $300,000, that's still enough to generate $1,000 a month in income using the 4% rule.
While you might use that for planning, Adams says it's only a starting point. When people reach retirement, she recommends they take a commonsense approach and adjust their withdrawal rate when needed.
It's acceptable to splurge a little when times are good so long as you cut back when times are bad. Adams says it's more about discipline and common sense than the actual number.
"In 25 years, I haven't seen anyone run out of money because they're taking 4%, 5% or 6%," Adam says. "It's when they're taking out 10% that they get in trouble."
That's exactly what we need to know as we move toward retirement.