Last Modified on November 12, 2019

Retirement planning refers to saving money for when you finally decide to leave the workforce behind. In most developed nations, the age of 65, is traditionally seen as an acceptable time to retire. If we go by recent trends, we will find that an average American retires at the age of 62. This leaves them with an approximate retirement life of 18-20 years. A majority of Americans also retire before their planned retirement age. Increased life expectancy in the modern world further increases the length of their retirement. Logic compels us to have more savings in our retirement basket to sustain ourselves for all these years. And yet, many people tend to elude retirement planning from their goals.

Retirement planning is not limited to only saving money. A major component of the activity is also to manage it efficiently. This is why, it is important to understand the implications of the withdrawals that you make from your retirement accounts.  

Reasons for Withdrawal from your Retirement Corpus

There may arise a situation where you are forced to withdraw from your retirement corpus. This could be to fund your children’s college education, cover medical expenses, purchase a new house, etc. While there could be plenty of reasons to use these funds, one should only exhaust their retirement savings as a last refuge. Early withdrawal from any retirement account can trigger penalties and taxes. And there is always the extra burden of being inadequately prepared for retirement.

Safe Withdrawal Rate from Retirement Corpus

Safe withdrawal rate refers to the rate at which one can withdraw from their retirement corpus every year, so they do not end up exhausting these funds during their lifetime. Financial experts are of the opinion that the withdrawal rate can never be constant and should continually change over time. The rate is hugely dependent on a person’s savings. So, if you have a high withdrawal rate, you also need to save more. Practically, it relies on many factors and gives a clearer picture only when analyzed on a case-to-case basis.

The inflation rate also plays a major role in determining a safe withdrawal rate. For example, with 2% inflation, if the corpus is made up of $50,000, a 4% withdrawal rate means you can safely withdraw $2,000 in a year. Apart from inflation, changes in lifestyle and life expectancy also play a part in calculating the safe withdrawal rate. This rate works as a saving indicator too, reminding you to alter your savings as per your withdrawals. 

The 4% Rule – by Bill Bengen

In 1994, when Bill Bengen came up with his 4% rule, many began recommending the figure as a safe percentage to stick to, when withdrawing funds from retirement accounts. He analyzed historical data and concluded that a withdrawal rate of 4% for the first year could keep away the fear of running out of money for the next 30 years. Bengen later accepted the influence of inflation and in 2008, modified his rate to 4.5% to factor in the rising costs of the changing times. A 4% withdrawal rate is an accepted one and is easy to follow, especially by people who have just started their savings journey. However, critics argue that it may be a bit inflexible. A major drawback of the rule is that it does not take into account the changing patterns in the spending habits of people.

Alternatives to the 4% Rule 

Keeping in mind the inflexibility of the rule, two more approaches made it to the forefront: 

1. The Dynamic Approach: The approach offers more fluidity as compared to the traditional fixed percentage of 4%. This dynamic method allows you to change your withdrawal rate every year, keeping in mind the return from your investments. Ideally, if you have had low returns, you should maintain a low withdrawal rate. However, with better returns, you can give it a raise. The only disadvantage of such an approach is the complexity of calculating the minute details. But you can always lean on the expertise of a financial advisor for help.
    
2. The Bucket Approach: This approach reduces your investment risk by dividing your savings into several categories. You can keep multiple buckets for different needs. For example, a bucket for short-term goals, a bucket for long-term goals, and a bucket for unplanned goals. You can withdraw from your short-term bucket, leaving your long-term, riskier investments untouched. Since short-term buckets are usually kept in cash or cash equivalents, it is easy to rebalance them without affecting your retirement goals. A good example here would be to keep a bucket just to meet your emergency expenses, so you can save more in the long run.

To sum it up

The 4% withdrawal rate has been traditionally accepted as a safe withdrawal rate and has stood the test of time. However, sticking to a fixed rule may not always end up in favorable results. You should assess the situation on a yearly basis and keep track of your investment portfolio to determine an apt withdrawal rate. It is also important to keep in mind, the income from other sources, such as Social Security benefits, as well as to account for future inflation. Your withdrawal rate should be a realistic number that can serve your current and future financial needs. If you are too conservative, you may lose out on a better standard of living. On the other hand, an extravagant lifestyle can rob you of your savings in just a couple of years.

If you need help in striking the right balance and sticking to a withdrawal rate that aligns with your goals, reach out to financial advisors. These experts will guide you through the entire path of retirement planning.