How much money will you need for a comfortable and financially secure retirement? Many heuristics exist to help answer that question but their reliability has been challenged in recent years. For example, the popular “4 percent rule” suggests that if you withdraw 4 percent annually from the funds in your diversified portfolio of stocks and bonds, and regularly adjust for inflation, then you should have enough money to last for at least 30 years based on the historical returns of the U.S. stock market. The size of the nest egg that will be needed for retirement can then easily be derived by taking the annual income you expect to require in old age and dividing it by 4 percent.
However, the 4 percent rule was developed in the 1990s when bond yields were much higher, so its applicability during the low interest rate environment we are currently in is questionable. Further, even if inflation pressures in America pick up, officials at the Federal Reserve are likely to continue to move gradually with interest rate normalization, meaning that rates could remain relatively low for quite some time. What is worse is that recent research argues that even a reversion to more “normal” bond returns still might not be enough to make the 4 percent rule viable again.
One possible way to respond is to lower the annual withdrawal rate but for people with a fixed amount of retirement savings this could mean a dramatic reduction in their standard of living. As for those individuals who want to maintain a specific annual income in retirement, the reduced withdrawal rate would mean that they will need to have amassed a much larger nest egg. With a target annual income of $50,000, for instance, the 4 percent rule would require $1.25 million in savings, while a “2.5 percent rule” would demand and additional $750,000 in portfolio assets.
There are of course other rules of thumb available to use for retirement planning but such alternatives all have their own set of assumptions and risks. As a result, the key takeaway from all of this should be that successfully preparing for retirement will likely require the careful consideration of numerous variables, some of which may be unique to your situation and therefore cannot be properly encapsulated in a simple model. Fortunately, consulting with a professional advisor can help you identify all of the knowns and unknowns that may affect your old-age financial well-being, and in turn develop a tailored plan that helps you achieve your desired retirement outcome.
Sources: Journal of Financial Planning, Investopedia, CNBC, PIMCO
Post author: Charles CouchDisclosures