How much should I save each month for retirement? The answer depends on several factors, such as your age, income level, and investment strategy.

According to the Social Security Administration, the average American worker has only $1,500 saved for retirement. If you want to retire comfortably, you'll need to start saving now.

There are four main ways to invest for retirement. Each option comes with its pros and cons, so you'll need to decide which one is right for you. But regardless of your investment methods, or business ideas you still need a monetary goal to reach for.

After all, if you don't have a goal as to when you can retire and live of your investments, then what is the point in working towards towards retirement. This is where the 4% rule comes in to play.

What is the 4% Rule?

The 4% rule of thumb states that you should be able to withdraw 4% of your portfolio annually from your retirement fund without ever running out. This 4% rule however only works based on certain assumptions.

This works as the average portfolio return for an investor 7-10% annually. Assuming this return is achieved then 4% should never result in your portfolio reducing in size. In fact, you are more likely to see your portfolio grow over time as 7-10% growth with 4% taken out each year is still 3-6% growth. 

Using this rule we are able to then come up with certain values to act as our retirement goal. For example, I personally would be happy to live off £25,000 annually. This means my 4% withdrawal rate should be equal to the £25,000 I desire annually. 

To then workout how much I need invested I then multiply my desired annual return by 25. Why 25 you may ask? Well this is because 4% multiplied by 25 equals 100%. The 100% of course is our total portfolio required.

Therefore, to earn £25,000 from an investment portfolio, I should be hoping to accumulate an investment portfolio of £625,000 (£25,000 multiplied by 25). So know you all know my personal FIRE (Financial Independence Retire Early) goal.

The History of the 4% Rule

The 4% rule was first introduced by the economist Bill Bengen back in the 1990s. He said that retirees could withdraw 4% of their portfolios without running out of money.

He based his theory on the fact that people who retired early were living a longer retired life than those who didn't. Therefore they had more years to spend their retirement savings.

So knowing this he came up with the idea that the amount withdrawn should be proportional to the number of years spent.

Bill Bengen worked out the 4% rule by taking into account the following:

• Average returns of stocks and bonds over long periods of time
• Life expectancy at birth
• A reasonable inflation rate
• Inflation rates vary greatly depending on location. However, it's generally accepted that the US has

Bill Began has even stated that the 4% rule was also one of the more conservative options and that a 5% withdrawal rate is also a doable figure. Since then the 4% rule has been used by many financial planners and economists to help determine the optimal amount to save for retirement. There are different safe withdrawal rates but they often depend on your rate of return and risk tolerance.

Pros and Cons of the 4% Rule

Pros:

• Gives a goal to work towards. As mentioned at the start of this blog post, there is often no point working towards something if you have no goal. The 4% rule allows us to understand our investment goal so we can track our progress related to an actual figure.
• Provides confidence that retirement savings won't run out. A huge worry for someone in retirement is that they might run out of money in retirement. Utilising the 4% rule can give investors and retirees confidence that there investments will last as long as they need it to.

Cons:

• You may not achieve the expected 7-10% per year. Of course this is a big factor which could affect your retirement fund. If you don't grow your portfolio by the expected amount each year then when you come to withdrawing funds to fund your retirement life, your portfolio will actually lose size. This may be okay for a single year but over the long term this isn't feasable.
• Investment markets may change and 4% rule may no longer work. This point is similar to the previous in that if you don't receive the expected returns then the 4% rule won't work. This could be for varying issues other than just the return on investments. Tax rules could change, investing may change etc. Although there are less likely to be drastic changes which completely destroy the 4% rule, it is still a possibility.

Summary

Although the 4% rule is useful, it doesn't guarantee success. It only provides a guideline for how much to save and what to invest in. There are many factors which can influence your retirement including market conditions and tax laws.

If you want to find out more about the 4% rule or any other topic regarding retirement finances, please feel free to leave a comment down below or contact me directly through our contact page.

Thanks for Reading

FAQ

Does the 4% Rule Still Work?

The 4% rule was created to meet the financial needs of a retiree even during a worst-case economic scenario such as a prolonged market downturn. Many financial advisers say that 5% allows for a more comfortable lifestyle while adding only a little more risk.

Source: (investopedia.com)

When the 4% rule may be the wrong choice

If you want to be 100% sure you won't run out of money, following the 4% rule likely isn't the best choice. Not only is it an older rule, but it also doesn't account for changing market conditions. In a recession, it's probably not wise to step up your withdrawal amounts; you may even want to reduce them slightly. But when the markets are doing well, you might be able to withdraw more than 4% comfortably.

Source: (fool.com)

How do I account for inflation in retirement planning?

Inflation should always be a key part of your retirement plan, from the time you start investing until you're making your annual withdrawal plan. Since inflation tends to average between 2% and 3% per year, the total amount you'll need when you retire should account for that increase, and your annual withdrawal amount will need to increase based on inflation each year during retirement.

Source: (thebalance.com)