4% Drawdown Rule

4% Drawdown Rule

In any industry, there are generally rules of thumb to go by.  They aren’t necessarily hard and fast rules, but general guidelines to abide by.   When it comes to financial planning one of the quickest and easiest ways to determine one’s ability to retire is the 4% drawdown rule.

In short, this 4% rule is a quick and easy way to figure out how much one needs to save for retirement before they are in a position to retire.  Basically, the essence is as follows.  Take your investment accounts and multiply them by 4% or .04 for those mathematically challenged.  For instance, if you have $1,000,000 saved for retirement and multiplied that by .04 that would give you $40,000.  That $40,000 is what you can comfortably draw out of your investments each year to sustain a 30-plus-year retirement. 

Real World Example

Thus, if you are able to project what your annual needs out of your investments to supplement your lifestyle you can easily back into the loose amount you need to retire.  Let’s look at a real-world example.

Ex: Mr. and Mrs. Scooby Doo (always wanted to use that name) are approaching retirement.  They will have a $30,000 a year pension, and two Social Security payments equaling $60,000 a year.  Additionally, they know they need $150,000 a year to sustain their desired retirement lifestyle.  Knowing they have $90,000 a year in fixed income already it leaves their shortfall in the $60,000 range.  Assuming the 4% drawdown rule if you take $60,000 and divide it by .04 you’ll get $1,500,000 in total retirement savings needed to generate their $60,000 shortfall.

Now, there are certainly plenty of other factors worth considering in figuring out your appropriate figure.  Here is a list of other items I generally ask clients to think about when determining their retirement needs:

1. Will they be increasing their needs at all?
2. Will they be decreasing their needs at all, such as paying off a mortgage?
3. Are there large predictable expenses looming we need to calibrate for, such as home projects, big trips, or even a wedding for that princess of yours?
4. Any predicted medical needs?
5. What do you assume inflation will be over your lifetime? I’d use 3% for what it’s worth.
6. Taxes, taxes, taxes.  Don’t forget most likely a large amount of your funds will be in retirement accounts so you have to factor in you’ll owe taxes out of your funds.
7. Your risk level?  Will you be comfortable with market swings over your lifetime and exposing yourself to stocks and bonds?
8. How disciplined do you plan to be?
9. Will you be receiving any other inheritance to be factored in?
10. Any other incomes you intend to bring in, or willing to bring in if needed?
11. Are you willing or able to cut expenses if need be?

Once you get a good approximation of the above you can then fine-tune your needs.  Of course, I get to cheat when doing this as we have expensive fancy software that can help project all of this out.  Regardless, these items need to be factored into your retirement needs so we can most accurately project your lifetime needs, which is already very difficult or shall I say impossible to do. 

Other considerations

Now, I do think if things are tight you can likely move this 4% rule up to 5%.  As a matter of fact, here at Diversified, we have a great strategy for drawing down assets that fits right into this formula.  Remember once you figure out your needs in retirement, the hard part truly begins.  How are you going to invest and structure your assets with a battle-tested strategy to best position yourself for success?

This is an issue for most novice or DIY investors that I for one wouldn’t want to “learn on the job.”  Almost every investor up to the point of retirement has simply invested one way, how to maximize their risk-adjusted rate of return.  In retirement, the stakes are incredibly high and thus I highly recommend finding a financial partner you trust and who has extensive experience in retirement income planning, like us,  to help manage this process for you. 

Remember, in retirement, it isn’t all about maximizing risk-adjusted rate of return, it is also about optimizing your drawdown strategy so you live a comfortable, and ideal retirement.  Because let’s face it isn’t this why you worked and saved so hard all those years for?

There you have it folks, the 4% strategy in a nutshell.  If you or anyone you know needs help with this type of critical planning don’t hesitate to reach out as we are always eager to serve. 

Stay wealthy, healthy, and happy.