Everyone works hard and invests in the right avenues to lead a comfortable retirement. Take it on you – you might have plans to tour the world with your spouse, build your dream home once you have stepped beyond the working age, or live a peaceful life at home. You may invest in a suitable retirement fund after carefully analysing the investment amount using a retirement calculator.
That’s just one side of retirement planning. What about the other side, after you reach the minimum age to begin your retired life? How much money should you withdraw from your retirement corpus? This is where the 4 per cent rule of retirement comes into the picture. Let us help you understand it better.
What is the 4% Withdrawal Rule?
The 4 per cent rule says that an individual can withdraw up to 4% of the total value of their portfolio in the first year of retirement. This way, one can expect to outlive their money during retirement. In other words, *if you built a corpus of Rs. 1 crore by investing a certain amount in
retirement funds and other investment options, you can choose to spend Rs. 4,00,000 in the first retirement year.
*Note: This example is only for illustrative purpose.
Retirees can use this rule to decide their spending in the later years of their lives. The primary purpose of adopting this rule is to maintain a steady income stream while having an adequate account balance for the time ahead. By following this 4% withdrawal rule, you mayhave a high probability of not outliving the money you possess.
While this rule can help get a good start with financial planning for retirement, it may not fit well into every investor’s goals. This is because:
The rule assumes you increase the spending every year not with respect to the performance of your portfolio but by the inflation rate. This can be pretty difficult for many investors
Another assumption is that an individual will not have years when he spends more or less than the rise in inflation. This is different with retirement spending for most individuals
It uses historical market returns to reach the sustainable 4% withdrawal rate. In reality, historical averages are likely to be higher than market returns
It assumes a time horizon of 30 years after retirement. Depending on your lifestyle and age, you may not need to plan an income for 30 years after turning 60. Also, the average life expectancy in India is 70.42 years (2023)
It does not consider different types of taxes on gains and fees related to the investments
A common misconception around the 4% withdrawal rule is that individuals must withdraw 4% of their portfolio each year after retirement. The truth is, it is applicable to the first year only. After that, the inflation needs to be considered to determine the withdrawal percentage
How Does the 4% Rule Work?
Think of the 4% withdrawal rule as the guideline to estimate an average income for your retired years. Its working is relatively simple – add all investments to build the corpus for your retired life and then withdraw 4% of the total in the first year. In the subsequent years, you adjust the percentage to account for the inflation and then make the withdrawals.
*For instance, if the inflation rate is 3% and you have withdrawn Rs. 4,00,000 in the first year (4%), you could make it Rs. 4,12,000 (4,00,000 x 1.03) in the subsequent year. In case the inflation goes down by 3% (rare-case scenario), you could withdraw an amount lesser than the first year, i.e., Rs. 3,88,000 (4,00,000 x 0.97).
For a 30-year retirement, the 4 per cent rule of retirement will help you avoid financial dependence during the retired life.
Additional Read: How To Plan Your Retirement with Mutual Funds?
History of the 4% Rule
The 4% withdrawal rule was created in the mid-1990s by Bill Bengen. He considered the retirements starting over a 50-year period from 1926-1976 and considered actual market returns beginning from 1926. All this quantitative analysis helped him evaluate the portfolio's longevity for a 50-year period.
He found that the initial withdrawal at the rate of 4% can enable most portfolios to last for 50 years or even more, hence the name ‘4 per cent rule’. Even in the worst-case scenario, the portfolios lasted for 35 years at least.
If you, as an investor, want to follow this rule, you must be aware of the underlying assumptions and cross-check the investment plan using a
retirement calculator. The rule is based on precise constraints around asset allocations. Also, inflation, related fees, and market risks can lead to different outcomes for multiple individuals following the same 4 per cent rule. It may also not apply to those who would like to pay an investment advisor.
Advantages and Disadvantages of the 4% Rule
The pros and cons of following the 4% withdrawal rule differ from individual perspectives. In general, following this rule can helpmaking the retirement corpus last the remaining years of life, but cannot guarantee the same. Secondly, the rule is based on past market performance and may not predict future occurrences equally well. Also, what was considered the safest investment option in the past may not be safe as per the present market dynamics.
Besides this, the 4 per cent rule may only work in some scenarios. For instance, a severe market downturn may lessen the value of a risky investment option much faster than traditional retirement plans. Similarly, violating the rule for significant spending during retirement can have unexpected consequences down the road. Such an act will reduce the principal, impacting the compound interest.
The following table summarises the advantages and disadvantages of the 4 per cent rule:
|
Advantages |
Disadvantages |
| It is easy to follow | It requires strict adherence during the retired life |
| It provides a steady income to retirees | It is based on the historical market performance |
It can protect an individual from
running out of funds during retirement | It may not work in case of sudden big purchases or spending |
Conclusion
The 4% rule can be considered reliable in various market conditions. Since no one can predict the future, it is essential to rationalise both the investment and withdrawal decisions accordingly.
Generic Disclaimer:
The information herein is meant only for general reading purposes, and the views being expressed constitute opinions and, therefore cannot be considered as guidelines, recommendations or a professional guide for the readers. The document has been prepared based on publicly available information, internally developed data, and other sources believed to be reliable. The sponsor, the Investment Manager, the Trustee or any of their directors, employees, associates or representatives (“entities & their associates”) do not assume any responsibility for or warrant the accuracy, completeness, adequacy and reliability of such information. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice to arrive at an informed investment decision. Entities & their affiliates, including persons involved in the preparation or issuance of this material shall not be liable in any way for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including on account of lost profits arising from the information contained in this material. The recipient alone shall be fully responsible for any decision taken on the basis of this document.
Calculator-related Disclaimer:
The above results are based on an assumed rate of return. Please get in touch with your professional advisor for a detailed suggestion. The results are based on an assumed rate of return. The calculations are not based on any judgments of the future recovery of the debt and equity markets/sectors or of any individual security. They should not be construed as a promise on minimum returns and/or safeguard of capital. While utmost care has been exercised while preparing the calculator, NIMF does not warrant the completeness or guarantee that the achieved computations are flawless and/or accurate and disclaims all liabilities, losses and damages arising out of use or in respect of anything done in reliance of the calculator. The examples do not represent the performance of any security or investments. Considering the individual nature of tax consequences, each investor is advised to consult his/ her professional tax/ financial advisor before making any investment decision.
Mutual Fund Investments are subject to market risks, read all the scheme related documents carefully.
