Most of us hope to retire someday but saving for retirement can be confusing. How much money do you need to retire? One simple and easy rule of thumb, known as the “4% Rule” is a great starting point for your retirement planning. It’s not a magical concept or a hard and fast rule, but it can give you a clear savings target and help you learn if you’re on the right track toward retirement success.
Americans Aren’t Saving Enough for Retirement
Unfortunately, the dream of retirement seems to be getting farther and farther away from many Americans. A survey by the Federal Reserve showed that the median retirement savings for Americans ages 55 to 64 was just $134,000. That’s not enough for most Americans to retire and maintain their standard of living.
Perhaps one of the reasons so many Americans aren’t ready for retirement is that it can be hard to figure out how much money you’ll need to retire. This makes it difficult to know how much to save for retirement each month, especially for younger people who may be tempted to spend their money on the here and now.
The 4% Rule is an easy way to create a clear retirement savings goal.
What Is the 4% Rule (or Rule of 25)?
The 4% Rule is a guideline designed to allow you to retire with a relatively high level of certainty that you won’t outlast your savings. The idea is to save up enough money so that you can cover all your yearly expenses by withdrawing just 4% from your savings each year. The way to determine your ultimate retirement number is to estimate your yearly expenses in retirement and multiply that number by 25.
Confused? Let’s take a look at an example of the 4% Rule.
Amy has saved $1 million and wants to know if she has enough money to retire. She estimates that she needs $5,000 a month in retirement to maintain her lifestyle, or $60,000 a year. By multiplying $60,000 by 25, she gets her retirement number under the 4% Rule: $1.5 million (4% of $1.5 million is $60,000). In this scenario, Amy has not saved up enough money. We’ll look at some of her options later in this article.
How the 4% Rule Works
The 4% Rule has been around since the 1990s and is popular in many financial and retirement circles. The underlying belief is that by following the 4% Rule, retirees have a strong chance of outliving their money.
The thinking goes that, ideally, your retirement savings will generate at least a 7% return each year through interest and dividends. With an average inflation rate of 3% per year, your retirement savings will grow by 4% each year. If you only withdraw 4% of your savings each year, you’ll never draw down your principal savings. Those savings will just keep generating your living expenses for as long as you are retired.
The 4% Rule is widely attributed to a financial adviser named Bill Bengen who created the rule after reviewing 50 years of historical stock and bond market data. His research included the Great Depression and the inflation-led recession of the 1970s. Many people who follow the 4% Rule believe that a 4% withdrawal rate is conservative enough to protect your principal savings in almost any financial market.
It’s important to recognize that the 4% Rule is only a guideline, not a hard and fast rule. There is no guarantee that the rule will work for you. After all, past performance doesn’t guarantee future results. However, adherents believe this rule offers them the best chance for a successful retirement.
Benefits of the 4% Rule
Simplicity
The biggest benefit of the 4% Rule is that it is simple to understand and utilize. All you need to do is estimate your yearly budget in retirement, multiply that number by 25, and you have your retirement savings number.
Data backed
The rule was designed using historical data from the financial markets and has been shown to hold up in a wide variety of market conditions. This doesn’t mean following the rule will guarantee retirement success, but it does have a good track record.
Money left behind
One of the primary goals of using the 4% Rule is to rarely if ever withdraw from your principal savings. If all goes according to plan, you’ll leave this principal amount behind after you pass. This is money you can bequeath to your children, family members, or causes you believe in.
Drawbacks of the 4% Rule
High savings rate
The 4% Rule is generally considered to be a conservative calculation. Since the point is not to withdraw from your principal savings, you’ll need to save a large amount of money so that the returns it generates cover all your expenses. Considering that many Americans struggle to save adequately for retirement, the 4% Rule may not be achievable for many.
Big changes can distort the calculation
The 4% Rule is based on the assumption that the financial market and the economy will continue to function within historical parameters. What happens if those assumptions aren’t true? What if the stock market takes a long, extended nosedive or if inflation climbs for a decade or more? Major swings in the financial market may make the 4% Rule less safe. For this reason, some highly conservative retirees adhere to a 3.5% withdrawal rate or even a 3% withdrawal rate.
Not using the principal
What if you’re not interested in leaving behind a large nest egg? Some retirees prefer to increase their withdrawal rate to 5% or even 6% per year, which can allow them to take more money out of savings each year or retire with a smaller nest egg. The tradeoff is that there is a higher chance that the earnings from their retirement savings won’t cover the full withdrawal, which means the retirees will begin drawing down on their principal. As the principal amount decreases, it will generate a lower return each year, meaning the retiree will have to take more and more from the principal. This scenario could quickly spiral, creating the possibility that the retirement savings is depleted before the retiree passes away.
Unpredictable expenses
The 4% Rule assumes that a retiree’s expenses will stay relatively consistent throughout their retirement, but life rarely works this way. What happens if the retiree gets sick and needs expensive care that goes beyond Medicare and Medicaid coverage? (This is a good reason to consider investing in long-term care insurance.) Or what if a family member needs financial assistance?
Anything can happen in the real world, and a couple’s expenses can change over time, especially as their medical needs grow.
The Importance of Estimating Your Retirement Expenses
The best way to ensure your success using the 4% Rule is to estimate your retirement budget as accurately as possible. Many retirees make the mistake of assuming their current budget will be the same in retirement.
In fact, your costs will likely change in a number of different ways when you retire.
For example, you may decide to downsize after you retire or to move to a cheaper part of town now that you don’t need to be at the office. Living in a less expensive property could significantly reduce your monthly expenses.
Alternatively, you may wish to move into your dream home during retirement or to increase your travel. These actions could significantly increase your monthly expenses.
Think carefully about what you want your retirement to look like and how much that life will cost. Ask yourself questions like:
- What will my housing costs be?
- How often will I want to travel?
- How often will I want to purchase a new vehicle?
- Will I be financially supporting children or family members?
- Are there any big expenses I expect for the future, like a kitchen renovation, solar panel installation, or a round-the-world trip?
It’s always a good idea to give yourself wiggle room and estimate a higher monthly budget than you expect. This way, if you face an unplanned expense or if inflation increases more than normal, you’ll have some financial breathing room.
Add Your Income to the 4% Rule
Don’t forget to add your retirement income to your 4% calculations. The more income you earn in retirement, the less you’ll need to have saved before you retire.
Income can come in many forms, but the most common are:
- Social Security
- Pensions
- Real estate income
- Annuities
- Part-time job
For example, we know that Amy’s retirement budget is $5,000 a month or $60,000 a year. Following the 4% Rule, she’ll need to save $1.5 million before she can retire. However, let’s say that she decides to take Social Security at age 65 and receives $1,200 a month.
Now, she doesn’t need to withdraw $5,000 from her retirement savings each month. Instead, she only needs $3,800 a month or $45,600 per year. Her $1,200 in Social Security will bring her up to $5,000 in monthly income. Using the 4% Rule, $45,600 multiplied by 25 means Amy needs to save $1.14 million to hit retirement instead of $1.5 million. That’s $360,000 less she needs to save.
What You Can Do to Make the 4% Rule Work for You
The idea of saving $1.5 million may seem impossible to you, but that doesn’t mean you have to give up on the 4% Rule. There are many ways to make the 4% Rule work for you.
Save as early as possible
The best way to ensure you make it to your retirement number is to begin saving for retirement as early as possible. The power of compound interest can grow even a modest amount of monthly savings into a big number if given enough time.
If Amy saved $250 every month starting at age 20 and earned 8% interest every year, by the time she turned 65, she’d have $1.16 million in her retirement savings. This amount, along with her $1,200 monthly Social Security check, would allow her to live on $60,000 a year with a very low risk of depleting her retirement savings.
Are you a little late to the savings game? It’s never too late to start saving for retirement. Save as much as possible and increase your savings rate with each promotion and salary boost you earn.
Lower your monthly budget
Since you can’t get into a time machine and start saving for retirement at a younger age, another very powerful way to hit your retirement number is to lower your monthly budget in retirement. Consider downsizing or buying used cars instead of new cars. If you are used to going out to eat several times a week, what about making more meals at home? Since you’ll be retired, you’ll have time to learn new recipes and even batch cook for the week using an Instant Pot.
Were you planning on lots of international travel? What about switching to one big overseas trip every few years with more local trips in-between? The United States is filled with amazing and low-cost places to visit.
Let’s say that Amy decided to downsize in retirement. Instead of needing $5,000 a month ($60,000 a year), she realized she only needed $4,000 a month, or $48,000 a year. Now, instead of needing to save $1.5 million to cover her retirement under the 4% Rule, she only needs to save $1.2 million or $300,000 less. If she receives $1,200 in Social Security each month, she only needs $2,800 a month or $33,600 a year. Her retirement savings number would be $840,000.
Every $100 Amy can eliminate from her monthly retirement budget will translate into $30,000 less she has to save to hit her retirement number under the 4% Rule. Wow!
Part-Time Job
If you can’t save more money before retirement or lower your monthly retirement budget any further, the last best way to hit your retirement number under the 4% Rule is to increase your income. The income you earn during retirement will lower how much you’ll need to withdraw from your retirement savings. A part-time job, even for just a couple of years, can make a big difference to your retirement stability.
Let’s say that Amy has decided she can live on $4,000 a month ($48,000 a year) and earns $1,200 in monthly Social Security payments. Under the 4% Rule, she would need $840,000 to retire, but in this scenario, she only has $500,000 in retirement savings. To make up this difference, Amy takes a job as a cashier at a local grocery store. She works 20 hours a week and earns $1,200 a month after taxes.
Her monthly budget is $4,000, and she earns $2,400 in income ($1,200 from Social Security and $1,200 from her part-time job). She now only needs to withdraw $1,600 from her retirement savings each month, or $19,200 a year. Using the 4% formula, $19,200 multiplied by 25 means her retirement number is $480,000.
Amy’s $500,000 in savings is more than enough to cover the rest of her financial needs. In fact, with her part-time job, she may decide to hold off on taking Social Security until she reaches full retirement at age 67. This will allow her to receive a higher amount of Social Security.
Alternatively, if she found higher-paying work, she may be able to hold off on pulling money from her retirement savings for five more years. That’s five more years her savings has to compound. In either of these scenarios, Amy may be able to quit her job after just a few years of part-time work.
Is the 4% Rule Right for You?
Is the 4% Rule something you should follow in order to save for retirement? That’s entirely up to you. If you aren’t sure how much money you need to save for your retirement, the 4% Rule can offer you a simple-to-calculate target. The 4% Rule will also require you to come up with a retirement budget, which can be a very helpful exercise. After visualizing your retirement, you might realize you need far less money than you expected… or far more.
Either way, that information is valuable.
Best of all, the 4% Rule is not set in stone. If you want to be more conservative, you can use the 3.5% Rule. Or, if you can tolerate more risk, consider the 5% Rule.
It’s always a good idea to speak with a financial adviser or retirement specialist before making any long-term retirement plans. You can discuss the 4% Rule with your financial adviser and determine if this concept is right for you and your retirement.