If you’re like most retirees, you’ve spent much of your career accumulating assets to fund your retirement. You’ll likely rely on those assets to generate a portion of your retirement income. While you will likely have Social Security income and possibly even a pension, you may also need income from your savings.
The challenge for retirees is determining how much income to withdraw each year. If you take too much, you could deplete your savings and put yourself in a challenging financial situation later in life. Take too little, and you may struggle to cover your living expenses.
One commonly used approach is to take 4 percent of your savings balance each year as a retirement distribution. The idea behind this recommendation is that 4 percent is a modest amount that won’t deplete your savings and may even allow for some growth.
However, this rule isn’t right for everyone. There are several reasons why the “4 percent rule” may not be an effective approach. Below are a few areas in which this method may fall short:
Inflation and Market Volatility
One of the biggest issues with the 4 percent rule is that it often leads to a flat withdrawal. In theory, you would calculate 4 percent of your balance each year to account for changes in value. If your balance increases, your withdrawal goes up. Similarly, if your balance declines, so too does your distribution in the coming year.
In reality, though, many retirees fail to recalculate their distribution each year. They set a 4 percent withdrawal rate and keep it constant. This is problematic because it doesn’t account for inflation. As your cost of living increases, so too should your withdrawals. Otherwise, you may not be able to afford your lifestyle over time.
Another possibly more serious problem, though, is what happens when your balance declines. You may not be enthusiastic about decreasing your retirement account withdrawal and giving yourself a pay cut. Unfortunately, if you don’t adjust your withdrawal to account for the lower balance, you’ll end up withdrawing more than 4 percent. If your balance continues to decline, you could withdraw a substantial amount each year, thus depleting your savings and giving yourself little opportunity to regrow your assets.
The 4 percent rule also doesn’t account for your unique asset allocation. If you have an allocation that offers growth potential, then a 4 percent withdrawal could be modest. If you have a risk-free, conservative portfolio with little growth opportunity, however, a 4 percent distribution could be high.
It’s impossible to prescribe an optimal withdrawal rate without knowing how the funds are invested. Your withdrawal amount should be based on your specific needs, goals and objectives, and it should be aligned with your allocation and investment strategy.
Finally, one of the biggest issues with the 4 percent approach is that it isn’t specific to your spending needs. Your plans for retirement are unique to your goals and objectives. Your income strategy should be unique, too.
You may want to spend money in the early years as you travel and pursue favorite hobbies, then cut back on your spending as you get older. Or maybe you want to be conservative early in retirement so you have assets to cover health care or long-term care later in life. Maybe you want to minimize your spending so you can leave a significant legacy for your loved ones.
There could be any number of factors and criteria that influence your income needs. A better approach may be to build a budget that includes your specific spending goals and your projected retirement income. Then you can determine exactly how much income you should take from your savings each year.
Ready to develop your retirement distribution strategy? Contact us at Oliver Financial Group. We can help you analyze your needs and implement a plan. Let’s connect soon and start the conversation.
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