Sustainable Retirement: The 4% Rule

As we get older, there is one question that will undoubtedly cross your mind. That question is: “How much money can I afford to spend during my retirement?”. 

This is a completely reasonable question. After all, you’ve worked so hard to save up for your retirement; it is only natural that you would want to spend it all in your golden years. Unfortunately,  if you spend too much, you risk running out of funds. If you spend too little, you may not be able to live out the dream retirement you were hoping for.

Finding out how much you can really afford to spend in retirement is absolutely vital. To that end, the 4% rule might be able to help you manage your money well enough to ensure you have a stress-free retirement.

The 4% rule

So what is the 4% rule? The method was a suggestion by a financial advisor called William Bengen in a 1994 article. In his paper titled “Determining Withdrawal Rates Using Historical Data”, Bergen analysed half a century’s worth of market data. He concluded that essentially any potential economic scenario, even the most devastating ones, would allow for a 4% withdrawal during the year they retire and then would adjust for inflation each subsequent year for 30 years.

By following this formula, you should, in theory, have a very high probability of not outliving your money during a 30-year retirement.

For example, let us assume that your portfolio at retirement totals RM1,000,000. You would withdraw RM40,000 in your first year of retirement. If the cost of living rises 3% that year, you would give yourself a 3% raise the following year, withdrawing RM40,600, and so on for the next 30 years.

How the 4% rule helps

The one biggest advantage that the 4% rule provides is that it is simple. Budgeting can get very messy. Factors such as inflation, risk tolerance, income, savings, etc, can all go into determining how much you can afford to spend in retirement.

Having a guideline from retirement spending that’s this clean and simple makes planning much easier. If you are having trouble making your own retirement budget, the 4% rule is a good place to start. That being said…

The drawbacks

The 4% rule is not exactly foolproof. While it serves as a quick and simple guideline on how much to spend in retirement, there are a number of considerations that the 4% rule cannot take into account.

While it is a reasonable place to start it doesn’t fit every situation. A few things to take note of include:

You need sufficient savings

In order for the 4% rule to work, you will need enough savings so that withdrawing 4% of it per year will be enough to cover your cost of living and leisure. According to the Employees Provident Fund (EPF), the recommended amount of savings a Malaysian should have by age 55 is around RM240,000.

If we apply the 4% rule to this amount, you will be withdrawing about RM9600 per year (RM800 per month), which is not exactly much. You will likely have to rely on other sources of income such as passive income or investments to help supplement your retirement spending.

Does not account for big changes 

The 4% rule assumes you increase your spending every year by the rate of inflation. It does not really take into account how your portfolio performs. It also operates under the assumption that your spending habits do not change all that much year-by-year, and that you never spend more or less than the inflation increase.

This is not likely how most people spend their retirement. Expenses may or may not change year after year, and the amount you spend may also change throughout retirement.

Unforeseen expenses

Building on the last point, any unforeseen expenses can throw a wrench into the 4% rule. One such example is medical expenses. Most of us will have some form of medical issue throughout our lives that require a trip to the hospital.

The chances of this happening more frequently increases with age. Certain medicines or medical procedures can be exponentially more costly than others. Needless to say that a longer life expectancy also means that you will likely end up spending more on medical bills.

Unpredictable markets

Market fluctuations happen all the time. As such, the economy is unlikely to stay perfectly consistent throughout your retirement years. While the 4% rule does account for yearly inflation, during a booming economic environment, withdrawing more than 4% annually might be perfectly fine.

Under poorer conditions, you might need to cut back on spending, even after accounting for inflation. The only real way to counteract this is to simply keep an eye on your money and act accordingly at any given time.

It assumes a 30-year retirement

30 years is not necessarily a bad assumption for your retirement, but it may not be needed or likely. The average life expectancy of Malaysians in 2022 is at 73.1 years only, according to the Department of Statistics Malaysia (DOSM). Even then, people aged 65 and above have an average life expectancy of around 15.3 years.

It is always encouraged to plan for a long retirement as people can live long past the average life expectancy. However, underspending can also lead to a potentially unsatisfying retirement. Once again, there are many factors to consider that are hard to predict unless you are living in the moment.

Should you use the 4% rule?

With all the number of unknowable factors affecting your finances in retirement, does that make the 4% rule useless? The answer is not at all. It simply needs to be adapted for personal use in order to be effective.

As with most financial rules of thumb, the 4% rule is less of a set-in-stone mandate on what to do and more of a well-informed starting place, from which your own personal retirement savings and spending roadmap can be drafted. While it does not solve all the financial problems you will face in retirement, the 4% rule can serve as a useful starting point.

That being said, if you have a healthy portfolio of diversified investments, it is entirely possible for you to withdraw more than what the rule states. iMoney can help connect you with a number of potential investment opportunities via its website. Investments such as unit trusts are particularly friendly towards first time investors.