When it comes to retirement, there are different philosophies for saving, spending, and preserving money. Some debates exist over common guidelines related to retirement withdrawal rates – meaning the percentage of total retirement savings that individuals plan to withdraw yearly to cover expenses. The most common is the 4% rule, suggesting that retirees can withdraw 4% of their retirement savings annually to avoid running out of money. There’s also a 7% rule that may benefit certain people. But do these rules work? Let’s start with the 7% rule.
What does the 7% rule really mean?
The 7% rule means that people can take 7% of their portfolio value in one year beginning in retirement, adjusted for inflation. Like the more popular 4% rule, it is a personalized spending rate using 7% instead.
For whom might the 7% rule work best?
Though less common than the 4% rule, it may be proposed for some retirees with high risk tolerance, aggressive investment portfolios, or shorter expected retirement periods.
What’s the problem with the 7% rule?
The goal of establishing a withdrawal rate is to set parameters for withdrawing money to use in retirement. It must be sustainable, meaning that a person’s money must last. If a person withdraws money too aggressively, they will likely deplete their retirement funds too fast. Per The Annuity Expert, the 7% rule “…is considered aggressive and risky, especially for those expecting a 20–30 year retirement.” They explain that the assumption behind this rule is that investments will earn at least 7% net of inflation every year. They explain that it implies that a person will maintain stable expenses, market conditions, and life expectancy. However, significant issues make the 7% strategy unreliable for most people. This includes:
- Market volatility: Per Investopedia, “Volatility is a measurement of how varied the returns of a given security or market index are over time. It is often measured from either the standard deviation or variance between those returns. In most cases, the higher the volatility, the riskier the security.” In a volatile market, one must carefully manage how much to take out of what accounts to mitigate losses. The unpredictability of financial markets can disrupt even the best retirement plans.
- Inflation: iotafinance.com explains, “The term inflation describes the phenomenon, and the measure, of the increase of prices in an economy over a period of time.” During periods of inflation, the price of goods and services goes up, making it harder for people to afford things. Inflation can erode retirement savings more quickly and leave people who failed to save enough or manage retirement spending in the lurch.
- Taxes: Taxes are essentially mandatory financial charges established by a government organization to support the government and public spending. Though taxes can fluctuate, rarely do they go down. Tax increases and unexpected taxes can eat into retirement savings. It is important to consider the effects of taxes on retirement savings and spending and plan accordingly.
- Healthcare costs: Healthcare costs, expenses incurred while seeking medical services or products, is considered expensive in the United States. Though Medicare covers some healthcare costs for seniors 65 and up, it is not a perfect system. Drugs.com describes that “American seniors struggle to pay medical bills more than peers in other wealthy countries.” They explain that while most seniors can (at minimum) access basic health services, it’s not on par with other countries. According to a team lead by Munira Gunga, a senior researcher with non-profit Commonwealth Fund, “When older people can’t afford the health care they need, it impacts the health system overall: beneficiaries avoid getting care, their health providers end up seeing sicker patients, and federal Medicare spending increases over the long term.” Therefore, health care costs can impact retirement finances for seniors.
Why is the 7% plan so challenging?
The 7% plan typically assumes a 30-year retirement time horizon. The plan is generally unsafe for retirees with limited means and those who are risk averse as a 7% withdrawal rate can deplete savings before the 30 years are up. This means that a person can outlive their money, which is no good. Individuals with guaranteed incomes like adequate Social Security or pensionmay also not need to withdraw at that rate if their income needs are already met.
Why would anyone use the 7% rule?
There are unique and less common cases where the 7% rule is favorable. If a person has the funds, a 7% withdrawal rate can provide more money in early retirement for lifestyle or travel. Or if a person retires at an older age with a shorter projected retirement, the plan may work well for them. People with higher-than-average returns on investments may also potentially benefit. Additionally, it can provide flexibility for some folks seeking early retirement. For instance, it may work for someone in their 50s relying on other income sources in the future. However, the 7% rule is not for everyone. Since retirement planning is not cut and dry, and independent factors come into play, people are encouraged to consult a financial advisor for retirement guidance.
Is the more well-known 4% rule better?
ARQ Wealth Advisors point out that the authenticity of the 7% rule is debated, and the 4% rule is more commonly used. The latter lowers one’s nest egg by 4% rather than a more aggressive 7%.Per ARQ Wealth, “It is better suited for retirees with longer investment horizons or those who prioritize security over higher initial withdrawals.”Despite being less extreme, it may be susceptible to some of thesame problems as the 7%, such as outliving one’s money, depending upon one’s retirement finances.
Why is flexibility key in retirement planning?
For clients on retirement budgets, safe investments and careful management coupled with flexibility is key. While the 4% rule is a good starting point for retirement planning, people must understand their limitations and be adaptable to circumstances.
Is the 4% rule a strict practice?
Per James Wilson, CPA, Senior Partner at MacAlpine Carll & Co. and Financial Planner at M C Wealth Management, not too many people use the 7% rule. “Though the 4% rule is used more frequently, it is not a hardened one. Rather, it’s a rule of thumb that helps retirees estimate their sustainable withdrawal rate to avoid outliving their savings. It enables retirees to establish an adequate income stream to live on with the goal of preserving their principal for as long as they can.” Wilson suggests that retirees consider their personal financial situations and factor in their savings and investments, expenses, risk tolerance and even the type of lifestyle they seek. Independent aspects should be carefully reviewed to help determine a sustainable withdrawal rate. Since one-size does not fit all, consult a financial professional for advice regarding retirement withdrawal rates.
Disclosure: This article is for general informational purposes only and is not intended as a substitute for professional advice.
