4% Withdrawal Rate

Since you’re reading a personal finance blog you’re probably already familiar with the 4% rule. However, for those who aren’t the 4% rule is basically a rule of thumb that many financial planners use to calculate a “safe” annual withdrawal rate from your retirement nest egg. This “safe” withdrawal rate is also supposed to account for inflation. So in my case I calculated that we’d need approximately $34,000 (then I added another 20% for contingencies) which comes out to approximately $40,000. So $1,000,000 X 4% = $40,000.

An easier way to figure out how much you need to save is to simply multiply your estimated annual spending by 25. So if you require $40,000 a year you would need an investment portfolio of $40,000 X 25 = $1,000,000

There are 3 major assumptions built into the 4% rule that you have to be comfortable with:

1. Your portfolio will generate annualized returns of 7%. So if you have a very low risk tolerance and plan to have a large percentage of your portfolio in bonds/cash than it wouldn’t be realistic to expect 7% returns.

2. The 4% rule assumes inflation is under 3%. So if we had a long period of high inflation the “real purchasing” power of your withdrawals would get eroded.

3. Future stock market returns are on average going to be similar to historical returns.

I would just like to reiterate the 4% rule is a “rule of thumb” and as such should be treated as a guideline and not an absolute. Using historical data it’s very probable that you won’t ever run out of money however, depending on when you retired there are times historically that you would have outlived your money. That being said there are also times where you’d end up with too much money.

In my case I’m using 4% as the maximum amount of money I’d like to withdraw annually. Some years I might not require the entire 4% withdrawal amount. I’m also building a very large margin of error into this calculation as both my wife and I also contribute to defined benefit pension plans at work. In my retirement planning I’ll be omitting the value of these plans and will also assume that neither my wife or I will ever inherit any money. We will also have money set aside to pay for university tuition for our two children that will not be included in the $1,000,000.