You may have heard of the so-called “4% Rule” which is the idea that a retiree can withdraw 4% of a portfolio’s original value per year and still be reasonably certain that their money will last as long as they do. Whether that works or not is dependent on many different factors, but it’s a guideline that could be a decent starting point for someone looking to fund 30 years’ worth of retirement from, say, age 65 to 95.
But what if you’re a lot younger than that – maybe in your early 40’s or even younger, and you’d like to retire at that age? Hey, it can happen under certain circumstances. How well does this “4% Rule” hold up?
Okay, let’s say you’re 40 years old, and you decide you need $100,000 of annual income with a 3% adjustment for inflation each year. That means you’d need a $2.5 million nest egg, which, at a 4% withdrawal rate, gives you the $100K that you need. What could go wrong? A LOT, as it turns out.
First, your money’s got to last for 55 years instead of 30. And if you’re taking a systematic withdrawal of your portfolio with a 60-40 mix of stocks and bonds, if the market performs poorly through the early years of your retirement, your money could very quickly run out. That’s called sequence of returns risk.
Next, if interest rates and economic growth remain low, we could be facing lower market returns than what we’ve seen in the past. If your money has to last 50 or more years, market returns become even more critical.
Third, with so much time ahead, you’ve got a greater risk of unexpected spending shocks, like a health issue or large home repair. These things can really eat into your nest egg.
And at age 40, you’re also 25 years away from Medicare, which means you’ve got to fund your own health care needs – not cheap!
All of this means that a 4% withdrawal rate may be far too aggressive, the younger you are when you retire. An analysis by The Capital Group Companies determined that the maximum safe annual withdrawal rate for a 40 year old is roughly 3.38% – and it goes down to 2.79% if you factor in spending shocks and lower future returns in the market.
So keep this in mind if you want to retire early. With a longer retirement to fund for there’s potential for a lot more uncertainty. This is yet another reason to talk with an advisor and have a strategy.