There are many formulas that are supposed to help ensure you don’t overspend your retirement savings. One of the most popular, and—as such—relied upon is the 4 percent rule. This is a withdrawal rule that limits the amount of your annual withdrawals to just 4 percent of your retirement savings balance. The expectation is that this will restrict you to withdrawing only gains and not touching your principal.
Sounds reasonable—so what’s the problem? Well, in recent years we’ve seen such a low interest rate environment that withdrawing 4 percent could actually mean dipping into your principal. The more you dip into principal, the less you can earn the following year, which means the more you have to dip into principal the next year when you take 4 percent out. This leads us to something called “sequence of returns risk.”
Sequence of Returns Risk
Believe it or not, the way your retirement account performs in the early years will have a major impact on how long your savings last. Sequence of returns risk is the possibility that low returns early on in retirement while you’re making withdrawals will significantly reduce your growth potential, lock in losses and deplete your retirement savings long before you had planned.
Think about it this way: if you have $100,000 saved and you make a 6 percent return, then you will have $106,000 at the end of the year. If you take 4 percent of that out, then you’ll have $101,760 left to grow the next year.
But let’s say instead you make only 2 percent on your $100,000. That means your balance at the end of year one is $102,000. Taking 4 percent out leaves you with $97,920. Even if your returns start accelerating, you still have less money invested than you would in the previous scenario, which means you have less potential for growth.
Retirement plan design is an art that must consider many different possibilities, scenarios and risks. The biggest mistake you can make is approaching it with a one-size-fits-all attitude.