The 4% Myth: Where the Wisdom on Retirement Goes Wrong

The conventional thinking on spending money in retirement isn't really true.

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If you’ve ever gone to a financial planner or used a standard retirement planning calculator, you were probably horrified to learn that you’d need to save a huge amount of money – perhaps as much as $2 million – to maintain your standard of living in retirement.

Well, you can start breathing a little easier. It’s not really true.

Of course it would be nice to have that $2 million. But the belief that anything less means failure causes many people to become discouraged and give up on retirement planning altogether. And let’s get real: Most people retire with less than $2 million – some with a lot less.

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You do need to invest so that you won’t suffer losses so big that you can never fully recover. That’s true both while you’re working and after you retire. But there are a variety of ways to protect your principle, and trying to pile up a huge amount of money is only one of them.

At the heart of the issue is the standard advice that you should spend just 4% of your savings in the first year of retirement and increase the dollar amount at no more than the rate of inflation in following years. But that seems awfully stingy when you consider that stocks have historically returned an average of more than 6% after inflation.

The 4% withdrawal figure is designed to ensure that even in a terrible stock market, you won’t liquidate your principle too fast. Setting your withdrawal rate very low to begin with provides a cushion against a bad stretch in the stock market like the past few years.

That makes sense if you can afford it, but the 4% figure is unrealistic for many people and is also based on all sorts of unstated assumptions. You need to examine these if you want to get the most out of the money you’re actually able to save.

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The first assumption is that savings and investments have to provide all of your income during retirement. In fact, Social Security will continue to exist and probably won’t be cut much for anyone who is in or near retirement. You may also have some other sources of income – part-time work, for instance. Or you may have other assets you can tap – the cash value of an insurance policy or equity in your home.

Another assumption built into the 4% rule is that once you set your withdrawal rate, you can never change it. If fact, you can be flexible. If you are prepared to withdraw less for two or three years when times are bad, you’ll actually be able to withdraw more over the long term.

Perhaps most significantly, the 4% rule also assumes that you’ll invest in a stock portfolio that requires you to sell shares to get the income you need – with the result that if stocks prices are depressed for a long while, you’ll chew through your principle much faster than expected. But as I’ve written in previous columns, it’s actually simple to invest in a way that never forces you to sell stock if you don’t want to.

Specifically, you can buy stocks with above-average dividends, as well as high-yielding fixed-income choices, so that your portfolio pays more than 4% a year overall. Dividends typically are raised more or less in line with inflation. Growth in your annual income may lag for a year or two, but over time you should keep up, and the eventual appreciation of your stocks will give you capital gains that you can cash in when you need them.

In the current economy, such a portfolio also makes sense for younger people who are saving for retirement. Whatever age you are, right now you need to hedge against losses, lock in as much income as you can, and still keep the largest chunk of your money in stocks, so that you’ll participate in a broad market advance when the recovery finally takes hold.

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