A Better Alternative to the 4% Rule?
As you get older, the biggest financial challenge you'll face is deciding how much money will be enough for you to live on throughout your retirement. Given that you'll have to live with the consequences of the decision for the rest of your life, it's important not to make a mistake.
Some financial planners prefer to keep things simple. But simple rules don't always work as well as you'd like. By contrast, new research from Boston College's Center for Retirement Research adds a little complexity to the equation, but it may make your lifestyle a little more comfortable later in life.
One of the most popular rules for figuring out how to budget in retirement is called the 4% rule. The idea behind the 4% rule couldn't be simpler: When you retire, add up the value of all the investments you own. Take the total and multiply it by 4%. That figure becomes the amount that you're allowed to withdraw from your retirement savings during the first year of your retirement. Then, every year after that, all you have to do is take whatever the previous year's number was and increase it by the rate of inflation, keeping the purchasing power of your withdrawal constant.
The 4% rule is popular for several reasons. Its simplicity is obviously a big draw. But almost as important is the fact that retirees prefer to withdraw income and preserve principal, and you can find plenty of investments that pay 4% or more. Even among blue chip dividend stocks, Altria (NYS: MO) , Eli Lilly (NYS: LLY) , and Dow Chemical (NYS: DOW) all sport yields safely above 4% and also offer opportunities for further income growth down the road.
As easy as it is to follow the 4% rule, though, it doesn't always give the best results. Two years ago, a paper from Stanford University professor and Nobel Laureate William Sharpe pointed out a couple of flaws with the rule. On one hand, if you have a big down year early in your retirement that reduces the value of your savings significantly, taking withdrawals based on your much-higher previous total assets can lead to your taking out dangerously high percentages of your current portfolio. Conversely, later in life, the 4% rule can lead you to withdraw less than you can afford.
That's where the Center for Retirement Research's study comes in. Rather than making a single calculation at the beginning of your retirement, the paper looks at following what's known as the required minimum distribution, or RMD, rules.
The RMD rules are what the IRS uses to figure out how much retirees are required to take out of their tax-favored retirement accounts every year. The RMD is expressed as a percentage of your overall retirement account balance, and that percentage is based on your life expectancy. Although the rules don't kick in until age 70 1/2, the IRS has charts that give you the appropriate figures for younger ages. The percentage goes up gradually throughout your retirement, starting around 4% to 5% at age 65, rising to around 6% at age 70, and approaching 10% at age 80.
Clearly, getting that much income creates a big challenge, especially under current conditions in which finding high yields is a big problem. Most high-quality bonds won't get you close to 6%, let alone 10%. Some preferred stocks will get you there, and double-digit yields from business development companiesProspect Capital (NAS: PSEC) and Apollo Investment (NAS: AINV) could get the job done.
But given that you won't want to concentrate only in high-yield investments, you'll need to change your mind-set and think about taking principal rather than living on income. That's a big adjustment, but as you grow older, it starts to make sense -- as long as you're comfortable with the idea of spending everything you have and not leaving a legacy for your descendants.
Just as the 4% rule sometimes leads to too conservative results, using the RMD rule may often be too aggressive. But as endpoints to help you find a reasonable middle ground, taking both rules into consideration makes a lot of sense.
Of course, the other way to make your retirement more secure is to invest better. The Motley Fool's latest special report will give you all the details you need to get a smart investing plan going, plus it reveals three smart stocks for a rich retirement. But don't waste another minute -- click here and read it today.
The article A Better Alternative to the 4% Rule? originally appeared on Fool.com.Fool contributor Dan Caplinger likes rules that work. You can follow him on Twitter @DanCaplinger. He doesn't own shares of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy gets you the information you need.
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