Last Updated Oct 6, 2010 5:40 PM EDT
The beauty of the 4% solution is also its downfall, however. It's simple. It is so easy to use that you might be tempted to attribute more certainty or applicability to the rule than it really has. Here are some things to keep in mind.
It's not really 4% The often stated shorthand version is that you can withdraw 4% of your money every year, but that's not correct. Instead, it's 4% of the nest egg you have when you start retirement. You then increase that amount by the rate of inflation each year. So if you enter retirement with a $2.5 million nest egg and inflation runs 3%, you can safely withdraw $100,000 in year one, $103,000 in year 2 and so on. That way, you preserve your standard of living.
It doesn't really apply to everyone The research that underlies the 4% solution is what's called a Monte Carlo simulation. It tests the probability that you can achieve a particular investment goal under particular assumptions, based on history. In the original research that discovered the 4% sweet spot, financial planner William Bengen stated the goal as making your money last at least 25 years, and the assumptions included that you invest your nest egg in a continually rebalanced 50/50 split between stocks and bonds. If you aim to retire at, say, 50-in which case, you need your money to last more than 30 years-or if you keep all your money in bonds or all in stocks, your safe withdrawal rate won't be 4%. It'll be lower.
It's not really a sure thing Monte Carlo simulations express their answers as probabilities, which is the only honest way to state any prediction about the future. The 4% rule, properly put, gives you a 90% chance of not outliving your money. So even if you exactly meet the assumptions, you still have a slight chance of running out of money before you run out of lifespan.
There's a garbage in/garbage out problem Monte Carlo simulations are based on investment history. They test your strategy against thousands of possible combinations of events, but even so, the range of what's considered possible is bounded by what has happened in the past. However, in the past, we never had a $1.6 trillion federal budget deficit. We've never had a persistent zero-interest-rate-policy on savings, let alone Islamic radicals, a capitalist China, or any number of volatile conditions that could skew future results outside the range of past experience. And Monte Carlo doesn't even pretend to account for unforeseen personal events--an expensive illness, a natural disaster, a crime--that could take a chunk out of your nest egg as surely as a bear market.
Still, in an uncertain world, it's the best we got Think of the 4% target as a starting point and be ready to cut your spending if investment outcomes are a lot worse than envisioned in the Monte Carlo simulation. (They could turn out better, too, of course, but that's a classy problem to have.) And a 4% target is a lot better than the 9% or 10% withdrawal rate that pre-retirees often estimate is a safe withdrawal rate, despite widespread publicity about the 4% figure. A rule of thumb, in other words, is better than keeping your thumbs in your ears.
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