That Makes Cents: What is the "Four Percent Rule"?

That Makes Cents: What is the
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Retirement. A word that holds out the promise of an easy life at some point down the road, but also calls to mind less happy thoughts, including "What happens if I live long enough that the money runs out?" A valid question, especially because most Americans don't put away enough money to make retirement easy – or, too often – even possible. Here's where the four percent rule comes in.

The Four Percent Rule

Let's assume you're in that lucky minority of Americans who are saving for retirement throughout your working career. One rule of thumb financial planners often use proposes that each year in retirement you're going to need a minimum of 70 percent of your income in your pre-retirement year.

So, if you're making $65,000 a year and getting ready to retire, you'll likely need at least $45,500 a year. Some of this may be your social security or a (increasingly rare) an independent company retirement plan, but the rest needs to come from retirement savings. The four percent rule proposes that in order not to outlive your retirement, you should spend no more than four percent of retirement savings each year.

An Example of How This Works

Assume, for example, that your annual income is $65,000 and that at age 67 you'll have $500,000 in retirement savings. Four percent of $500,000 is $20,000 – that's the amount you can safely withdraw from your retirement savings each year. Assume also that your company has an actual pension plan independent of a 401k plan that's scheduled to pay you $18,000 yearly and that your Security Benefits pay another $19,000 each year. Your total annual retirement income (again, observing the four percent limit on retirement withdrawals) is $20,000 plus $18,000 plus $19,000, which is $57,000. You've got more than enough to retire comfortably without worrying that the money won't last long enough.

It May Not Pencil Out

Unfortunately, if you're like most Americans, you don't have anything like $500,000 in retirement savings and likely won't have it when you retire. One study found that the average 65 year old American has $177,000 in retirement savings. Invoking the four percent rule again, the average safe amount to withdraw from that $177,000 each year is only $6,408. Add to that another $19,000 in SS benefits and, assuming your salary at retirement is $65,000, you'll not have anything close to the estimated $45,500 annual amount you'll need in retirement.

What to Do About It

If you're reading this several years before retirement and can see that at the rate you're going, you'll fall short of what you'll need at retirement, one remedy is to change your attitude about saving for retirement and begin putting more money away so you'll have enough.

The first step is to face up to the reality of the situation, which you can do with any one of many available online retirement funding calculators. One that's effective and easy to use by CNN Money is included in this article's References. To see where you stand, you input your age, current income, proposed retirement age, how much in retirement savings you have now and the percentage of your current income you're currently saving. The calculator will output the amount of savings you'll have at your proposed retirement age.

If you see you're falling far short of your probable retirement income needs, increase your savings rate. Most all these calculators will show you in real time just how much difference the savings rate will make and the savings percentage you need to maintain from here on to get to that fully-funded worry-free retirement you're aiming for.

The Effect of Changing the Savings Rate

Here's an example of how you can make up for retirement savings shortfalls: You're 52 years old, making $50,000 a year and putting away about five percent of income in an IRA. You've currently saved about $70,000 and you want to retire at 68. Inputting this to the retirement calculator shows you that if you continue saving at your current five percent rate, at retirement you'll have only $205, 328 in retirement savings. Four percent of that is only a little over $8,200 – far short of what you'll need.

Your goal in this example is to get to an amount of retirement savings that will allow you to withdraw 4 percent from your retirement account each year to achieve total retirement income of $35,000. Begin by subtracting your projected SS income of $18,000 from the $35,000 total. Your net need is $17,000 each year. So how much in retirement savings will it take so that four percent yields $17,000? The formula is 17,000/.04 = $425,000, the amount of retirement savings you'll need.

Using the calculator again, you can see that if you increase your savings rate to 25 percent of current income, you'll have $434,105, a little more than you'll actually need.

How Hard Is That?

There's no doubt that going from saving five percent of your income each year to 25 percent is hard to do. One thing that helps is that when you have a 401k or an IRA, a portion of all your retirement savings is tax-deferred until retirement. The situation is different with Roth IRAs in that these are taxed when you put the money and that grows tax-free thereafter, but the tax advantages of all these retirement schemes are similar.

Another modification you can make that will make a big difference is retiring later than your original goal of retirement at 68. If you retire at 72 instead, you can reduce your savings rate to 9 percent of income and still have the $425,000 in retirement savings you'll need.

A Final Thought on the Time Value of Money

The earlier you begin saving for retirement, the lower the percentage you'll need to take out of each paycheck. Thanks to compounding interest and the time value of money, if you begin putting away 10 percent of a $35,000/year income at age 25, by the time you're 65, you'll have about $825,00 in your retirement account.