If you’re heading into retirement with a $5 million nest egg, congratulations.
Northwestern Mutual’s 2024 Planning and Progress Study found that the average American believes they’ll need $1.46 million to retire comfortably. However, according to the Federal Reserve, the median retiree closes out their career with just $87,000 to see them through.
So, with nearly 3.5 times what most people think they’ll need and around 57.5 times what the retiree in the middle actually has, you might feel like you’re entering your golden years with all the money in the world. But even real money like $5 million is finite, and with decades of retirement in front of you, it’s possible to spend yourself into financial insecurity if you don’t have a plan for how much to withdraw annually.
Here’s how to make sure you don’t outlive your hefty savings.
The 4% Rule Turns 30: Has It Aged as Well as Your Nest Egg?
Financial advisor William Bengen created the 4% rule in 1994, the same year Jeff Bezos founded Amazon, “Friends” debuted on NBC and O.J. Simpson went from famous to infamous.
Using historical market information dating back to the 1920s, Bengen outlined how much retirees can safely withdraw annually to ensure their money lasts at least 30 years, even as inflation diminishes its buying power over time.
The rule says to pull 4% of your savings in the first year of retirement to establish your baseline withdrawal rate, then increase your withdrawals in subsequent years to mitigate inflation.
A $5 million nest egg gives you $200,000 in your inaugural year of retirement, with your withdrawals growing incrementally each year to account for rising prices. But should you base your retirement plan in the third decade of the 21st century on a strategy that’s been collecting dust for 30 years?
Treat 4% as a Guide, Not a Rule
Considering how much the markets, economy and society have changed since 1994, any financial strategy as old as the 4% rule should be viewed with skepticism. However, the concept has mostly stood the test of time — with one big caveat.
“While the well-known 4% rule — withdrawals starting at 4% in the first year and adjusted for inflation thereafter — is a good starting point, it will likely underestimate how much most retirees can spend in retirement,” said Jeff Walters, a certified financial planner who worked with hundreds of retirees and pre-retirees for more than 20 years before retiring early himself and founding the financial blog Musings On Wealth. “This could lead to a lower lifestyle in retirement than could otherwise be achieved with a more dynamic method.”
The Flaws of the Retirement Withdrawal Gold Standard
Before adopting “a more dynamic” version of the 4% rule, as Walters suggests, it’s important to understand the shortcomings associated with the philosophy that has endured as the benchmark of retirement planning for 30 years.
According to Prudential:
- It treats 30 years as a safe, conservative, worst-case-scenario timeline that exceeds the length of most retirements. However, people live longer today, and a three-decade-plus retirement is no longer an outlier.
- The sequence of returns risk rule says that if the markets are down early in your retirement, your money won’t last as long.
- The 4% rule assumes you’ll receive full Social Security benefits throughout your retirement, but benefits could be reduced in your lifetime.
- The more you withdraw, the higher your tax bill is likely to be.
- Despite the long record of historical data Bengen relied on, there’s no accounting for unforeseen and unprecedented market crashes or periods of inflation.
- Healthcare costs now top $300,000 for the average retired couple, but unforeseen events and unplanned medical or long-term care expenses could send that figure much higher.
Adjusting the 4% Rule to Your Retirement: More Now, Less Later
The most obvious flaw with the 4% rule is that each retirement is unique and no single standard can apply to every individual. If you use the 4% rule as a guide, tailor it to your needs and keep it flexible to account for unforeseen events. However, one thing that retirement planners have learned in the last 30 years that does apply to nearly all retirees is that most can expect to spend more early on and less as they age.
“In my experience working with retirees, expenses before adjusting for inflation tend to be highest in the early years of retirement and slowly decrease over time,” said Walters. “By planning for this reality, a retiree can build a plan that will allow for a higher initial withdrawal rate.”
That means if you’re comfortable living on less later in life, you can withdraw more in the initial years — but how much more?
“Assuming a retiree is willing to make adjustments to their spending in the future and recalculate their withdrawal rate each year based on their actual results, I have been comfortable recommending as high as a 5% initial withdrawal rate,” said Walters. “Withdrawing $250,000 (5%) from a $5 million portfolio is reasonable if the retiree is willing and able to make small adjustments over the years to account for unexpected outcomes such as higher-than-expected inflation or lower-than-expected investment returns.”
