Financial planning is full of rules of thumb. One of the most famous is the "Four Percent Rule," which simply says that in retirement you can safely take out no more than 4 percent of the combined value of all of your financial assets each year with an expectation that your money will last 30 years or more, which is longer than the average length of time Americans spend in retirement.
However, the Four Percent Rule may be much more valuable as a guide rather than a steadfast rule.
A bit of history: The rule was originated by my fellow NAPFA member and fee-only financial advisor Bill Bengen. His conclusions, published in the October 1994 issue of the Journal of Financial Planning, were based upon a number of simulations of historical market behavior.
The result was a commonly used formula for managing retirement expectations, based on a number of assumptions about retiree needs and market performance. For example, at age 65 if you have a retirement portfolio of $1 million, and don't want to run out of money until you're 95, you can safely withdraw up to $40,000 a year.
But what if real life strays from these underlying assumptions? For example:
--What if you need more than 4 percent annually?
--What do you do if you live to be 100 or 110?
--What if you get really spectacular returns in your first few years of retirement so that by the time you're 95, you find you have a much bigger surplus than you expected? You may realize that you could have afforded a more comfortable lifestyle during retirement.
--What if, in the first few years of your retirement, the stock market drops by 45 percent?
Questions like these very quickly show the real value of the rule: it's a good place to start.
As a broad guide, the rule can be especially sobering for people who think they can withdraw 8-10 percent a year or more for 30 years. It's also a good number to use to guesstimate how much you'll need to accumulate to fund your retirement. For example, if you want $100,000 a year, it's going to take a nest egg of around $2.5 million in today's dollars.
The truth is that using the right withdrawal rate year after year is a lot more complicated than applying a simple rule of thumb. You need to take into account your health, your family's history of longevity, variable rates of return, your risk tolerance, and all of your goals, including what kind of financial legacy you may want to leave. Additionally, your needs might vary during retirement. You might spend more on travel and other activities during the early of your retirement, only to see these types of expenses tail off as you age. Later in your retirement years the cost of medical care might increase.
Ultimately, the only right way to determine how much you need in your retirement nest egg before you retire and how much you can withdraw annually once you're in retirement is to create a comprehensive financial plan and then update it at least once a year.
Roger Wohlner, CFP®, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides advice to individual clients, retirement plan sponsors, foundations, and endowments. Read more about Roger here.
More From US News & World Report