What is the 4% Rule Anyway?
Economists made it easy on us with this one. The 4% rule is exactly what the name implies: you should plan your savings retirement amount based on the idea that you will take out 4% per year. This is based on the idea that the market is expected to continue at a rate of about 7% each year over the next few decades. When you factor in inflation, that leaves you with 4% market growth that you can expect to live off while your retirement fund continues to generate income, untouched.
Now, of course, the market change might be higher or lower depending on the year, but in theory, that shouldn’t matter. As long as the overall trend goes up, your retirement account would do alright in the long run.
Not everyone agrees that this strategy is the best idea. Primarily if you’re investing in a lot of slow-growth, low-risk areas like bonds and blue-chip stocks, the 4% rule might be too risky. As with any strategy, it’s best to consult a financial advisor. The 4% rule can give you a simple benchmark to get started saving, as retirement saving goes. Still, you may encounter a few more confusing terms along with this rule. Let’s dive into some of those.
Safe Withdrawal Rate
The safe withdrawal rate is just that amount that calculates out to be 4% of your retirement savings. So if you saved $500,000, by the 4% rule, your safe withdrawal rate would be $20,000 each year. It’s a good idea to take a close look at your current income and how well it works for you now. Could you downsize in retirement to have lower expenses in order to need less in savings? Only you can decide what your financial needs are.
The Trinity Study
Now, all this 4% rule talk isn’t just pulled out of thin air. The Trinity Study is the informal name given to the paper, written in 1998 by professors of finance from Trinity University, that first launched the 4% rule. The paper built on concepts that were already at play, but it solidifies the idea of portfolio success rates that the 4% rule comes from. Based on history, it shows that the 4% rule has a 95% success rate. Now, of course, that’s looking at the past, and there’s no way to predict the future. But it still doesn’t hurt to take that research into account when you start your retirement savings saga.
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