Forget the 4% Rule: Here's What You Should Really Be Looking at During Retirement

The 4% Rule has long been a staple of retirement planning. The basic premise of that rule is that if you keep a well-diversified and balanced portfolio in retirement, you can withdraw 4% of the portfolio’s initial value in your first year of retirement. Then, you can adjust your withdrawal amount for inflation every year after that and have a very good chance of seeing your money last at least as long as your retirement.

While the 4% Rule is a great strategy for figuring out how much you should save for retirement, it’s less than optimal when it comes to actually managing your money once you’re retired. For one thing, people’s expenses — outside of healthcare — tend to decline the farther into retirement they get. For another, the 4% Rule is based on making it through a really tough economy and market. On average, with the 4% Rule, you’re likely to end your retirement with more than you started with.

With those realities in mind, it might be time to forget the 4% rule when it comes to how you spend your retirement nest egg. Instead, here are a few things you should really be looking at during retirement.

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What are your ‘must-cover’ costs?

You have to live somewhere, eat, wear clothes, and keep your home at a reasonably comfortable temperature. In addition, you may have or develop health conditions that you need to care for to enjoy your senior years. No matter how frugal you are with your money, you’ll have some costs you’ll have to cover throughout your retirement.

Knowing what those ‘must-cover’ costs are will help you understand how much flexibility you’ll have with whatever level of income you’re able to generate in retirement. The earlier you recognize those mandatory costs, the more potential flexibility you’ll likely be able to find in them. For instance, if your housing costs are too high, downsizing may help you reduce those costs and help your cash go further.

What guaranteed income will you have?

Most working Americans will qualify for some sort of Social Security benefit once they retire. That can provide you with a solid source of inflation-adjusted income to help cover your costs. You also may be eligible for a pension or have purchased an annuity that can provide a reliable source of cash to pay your bills.

With a good combination of planning, luck, and modest lifestyle needs, you may find yourself in a spot where your guaranteed income will cover your mandatory, core living costs. If that’s the case, your investment portfolio is generally available to cover the finer parts of your retirement. That gives you amazing flexibility when it comes to managing your costs in retirement.

How will you cover any shortfall?

If your guaranteed income doesn’t cover your mandatory costs, you should plan to hold at least five years’ worth of the shortfall in low-risk investments. Consider things like a savings account, certificates of deposit, or Treasury or investment-grade bonds scheduled to mature just before you need the money.

The stock market will never guarantee returns. While those other forms of investments may also run into troubles, they are more likely to deliver you the amount of money you expect at the time you expect it. When it comes to covering your bills, both those factors matter. A five-year buffer of higher-certainty investments gives the stock market time to potentially recover and you time to adjust if that recovery looks unlikely to materialize.

How will you keep that buffer funded?

As great as that five-year buffer can be for covering your nearer-term costs, the reality is that as those assets mature and you spend that money on your retirement, you’ll need a way to keep it funded. That’s where your dividend and interest income — as well as selling the stock part of your portfolio when the market is strong — can be useful in your plan and the original 4% rule can still come in handy.

If you invested enough to be covered by the 4% rule at retirement, your portfolio at that point will be large enough to cover around 25 years of your shortfall (before accounting for inflation). If you have around five years’ worth of those expenses in your buffer, you can keep around 20 years’ worth invested more aggressively in assets like stocks. (Although, after accounting for inflation, your stock portion may be a bit less.)

While the stock market will never guarantee returns, over the long haul, it has delivered returns that average around 10% on an annualized basis. That gives you a good shot of earning enough from your stock market returns in a normal market to keep that buffer funded. Of course, in a really strong market, you may want to sell a bit more to make that buffer a bit bigger. That way, when the market drops, you’ll be better able to wait out the decline.

Get started now

While the traditional 4% rule may not be ideal when it comes to managing your money in retirement, it still provides a decent guide for determining how much you should save. Coming up with 25 times what you expect you’ll spend from your portfolio over the course of a year can be easier said than done. So, get started today and give yourself the most time possible to build that nest egg between now and when you’re ready to retire.

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