How do you adjust the 4% Retirement spending rule for inflation?

Question

There is a "rule" that suggests withdrawing 4% of one's savings the first year of retirement, and then "adjusting for inflation" in subsequent years. This is supposed to ensure you will never spend all your money before you die.

I do not understand what the inflation adjustment means. If inflation the second year of retirement is 3%, how does one adjust the amount taken out of savings to maintain the 4% rule?

Vaya con Dios,

Tony in Idaho

Answer 1

Kindly note: Historical based analysis arrived at by searching for the worst case among all the possible 30 year intervals using the 1800s; therefore may not be entirely relevant today given that some distributions have changed.

The short of it: $1,000 monthly payments will have the buying power of just $401 in 30 years, ($1 today is worth less 30 years later, by the above projection, worth 40 cents.) Frank hit the nail it on the head.


The long ot it:
It's the maximum withdrawal one can take from an investment portfolio (stocks, equities) every year for 40 years, and in the worst times, the portfolio is unlikely to run dry.

Take a portfolio on an assumed retirement on 12/31/1871, adjust for actual market conditions with the given (inflation adjusted) withdrawal each year for 40 years.

Assuming retirement in 12/31/1872; XX/1873; XX/XX.
The withdrawal rate that would never result in a depleted portfolio is what a "maximum 100% safe rate", and works out to about 4% for a 40 year retirement.

Why not 5%? Historically, 5% withdrawal would deplete the portfolio in the worst of times, like the Great Depression where about 25% of possible retirement years since 1871, the portfolio would have gone bust before 40 years were up.

Why not 3%? If we decided on annual retirement of $40,000, 3% would require a portfolio of about $1.33 million, based on history, we'd be safe retiring with only $1 million in the portfolio. Chances are, $333,333 would take several years of extra work and investing, after we had achieved our financial requirements.

However, recent changes in the American economy and legislation may require the 4% to be adjusted. See first article.

Answer 2

You have $1,000,000.00 in the bank.
You are now 65 years old.
You could die at 85. (I asume you are healthy and you don't smoke)
You can survive with $50,000.00 each year until you die.
According to your rules you will only take $40,000.00 the first year.

The second year you have $960,000.00
You will take $38,400.00 the second year.

If you keep this up. You will never will run out of money until you die.

However, each year you will take less and less money and the final days will be dificult because you are almost at $0.00

If you have just $100,000.00 left you cannot take $4,000.00 to survive for an entire year. (Unless you move to Mexico of course, which by the way if the smartest thing you can do after retirement)

I asume your money is invested and your $960,000.00 will grow in the second year. That will smooth things a little.

Let's asume for a moment you have your money invested with Fidelity and after a year your $960,000.00 are now $1,000,000.00

You have exactly the same money than the previous year, therefore you can take out $40,000.00 one more time.

Alas, you cannot buy the same medicines and pay the same bills with that money because of inflation.

You have to adjust the money for inflation.

If inflation was 5% in that year you have to take $42,000.00 just to buy the same stuff.

It is wise to invest your money in something with bigger returns than inflation.

You have to make at least 6% to really make some money in these conditions.

I hope this helps.

Answer 3

You take out 4% of the balance in the first year and 3% more than that the next year. ($1000 in year one and $1030 in year two.) On average, the balance should go up due to investment returns more than 4%, so when you withdraw the 3% more the second year your balance will still grow. Averages are easy of course. You could lose money in any given year. You need to model it yourself, and not depend on rules of thumb. These rules are based on models of returns over many years, and show it's very likely you'll never run out - not that it's impossible.

Answer 4

Let's say that your first year you are withdrawing 10,000 dollars. The next year you will have to withdraw 3% (expected inflation)more because of inflation . Therefore year 2 you will need 10,300. If year 3 expected inflation is still 3% then you withdraw (10,300 + (10,300*3%)) = 10,609.