A:

The 4% retirement rule is often used by financial planners to set the amount that a retiree can withdraw annually from an investment portfolio. Four percent is considered to be a safe withdrawal rate that should allow the retiree's portfolio to provide a stream of income throughout retirement.

How It Works

A sample retirement plan using the 4% rule would begin by determining the value of all assets available to fund retirement. Then, the total assets are multiplied by 4% to determine how much can be withdrawn annually for retirement income.

For example, if a sample retiree has $1 million available to fund retirement, the plan would calculate annual withdrawals for retirement income in the first year of $40,000. The following year, 4% would again be applied against the new total balance to determine the next year's withdrawals.

Why It Works

The principle of the 4% retirement rule is that it should not only provide consistent retirement income, but it also should provide increasing retirement income. Since inflation causes the cost of living to increase over time, a retiree must consider that his income needs will probably increase throughout the retirement years. If retirement assets are invested well, the annual withdrawal rate of 4% should allow the total assets to continue to appreciate in value.

The annual income is based on 4% of the total assets. As the assets appreciate in value, additional annual income is available to the retiree. For example, if a new retiree's assets start at $1 million, earn a 7% return in the first year, and a 4% distribution is taken in the first year, $1.03 million or more should be available at the end of the first year. The following year, 4% of the beginning assets would provide $41,200 in distributions in the second year of retirement – a 3% increase in income from the first year.

Investment Performance Is Critical

The 4% rule can only provide increasing retirement income if the value of the investments in the retirement portfolio appreciates at a rate greater than 4%. Practically speaking, this means that a retiree cannot tuck retirement savings away in money market or certificate of deposit (CD) accounts, because those types of investments generally do not provide sufficient interest to cover the withdrawals.

Many financial advisers recommend that a fairly significant portion of retirement funds (50% or more) be invested in equities for the 4% retirement rule to be successful. Although equity investments tend to be more volatile in the short term, they have a higher historical rate of return over the long term than fixed income investments.

The key variable in a successful plan using the 4% retirement rule is the rate of return the retirement portfolio earns. The rate of return must be at least 4% and ideally should be at least 7% on average to provide the needed increasing retirement income.

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