How To Use The 4% Rule For Retirement Withdrawals


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The 4% rule is a key facet of retirement planning . The rule says that if you limit annual withdrawals from your nest egg to 4% -- or some similar rate -- your balance should survive 30 years.

That way, your money is likely to outlast you in retirement.

The 4% formula was arrived at using historical returns, inflation and life expectancy. The strategy works if withdrawing 4% a year plus the rate of inflation equals an amount that's less than your nest egg investment's rate of return.

How close would an investment in theS&P 500 ETF ( SPY ) have come in recent years? Despite historic downturns in 2000 and 2007, the ETF's average annual gain was 5% over the 15 years ended Aug. 5. It was 8.06% over the 10 years ended then.

The average moderate balanced fund -- typically 60% stocks, 40% bonds -- was up 5.6% and 6.7% a year in those two periods.

Some big, prominent funds have done even better. The $23 billion Fidelity Balanced Fund averaged 7.46% and 8.31% a year in those periods. The $20 billion Vanguard Balanced Index averaged 5.94% and 7.47%.

"The 4% rule is a good starting point," said Sharon Oberlander, managing director, wealth management, Merrill Lynch. "It depends on your age when you retire, your asset allocation and what degree of confidence you want that your portfolio will survive."

It is less likely to succeed for a 50-year-old who has a 100% bond portfolio, said Brian Layton, senior vice president, wealth management, Neuberger Berman .

Stick To Your Plan

One key to succeeding with the 4% rule is to stay the course, Layton says. In addition to a 4% withdrawal rate, select a stock-bond ratio that you are comfortable with.

You'll want a mix whose volatility you can live with, given the market's inevitable ups and downs. You want enough stocks for long-term growth.

Changing your asset allocation every time the market zigs or zags can be counterproductive. On the other hand, a strategic asset-mix shift based on age and circumstances, not daily market moves, is OK. "When you reach age 85, it's all right to focus more on preservation of principal," Oberlander said.

And how should you cope with inflation?

Michael Bilotta, senior adviser and CIO of JNBA Financial Advisors in Bloomington, Minn., says one option is to add an annual cost-of-living adjustment. A 2% COLA in the second year means a 4.08% withdrawal.

Changing Your Withdrawal

A second option is to change your withdrawal by half the rate at which the market changes. If the market rises 10%, give yourself a 5% raise, which equals a 4.2% payout.

A third option: when the market declines, cut your withdrawal by the same percentage, Oberlander says. When the market rises, don't change your withdrawal. Just let the extra earnings build up.

Fourth: calculate the dollar amount you need for annual living expenses. Adjust that by a COLA each year.

Fifth: Pick a portfolio, such as a 60-40 balanced fund or individual securities, whose annual return is likely to top your withdrawal rate. As your principal grows yearly, your payout of 4% or whatever gets a built-in COLA in dollars.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing Mutual Funds
Referenced Stocks: SPY

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