LOUISE FAIRSAVE: Retirement rules
THERE IS A RULE OF THUMB called the four per cent rule which can be applied to determine how much can safely be withdrawn from a retirement fund each year whilst maintaining an adequate fund balance to support future retirement years.
This four per cent rule assumes that the retirement fund achieves a four per cent return over a long term. It was developed based on the bond and stock market return performance years ago.
The rule says that in the first year of retirement, a retiree can safely withdraw four per cent of the retirement fund balance. Then, in subsequent years, the retiree can withdraw that same four per cent but adjusted for the level of inflation.
For example, given a retirement fund of $600 000, then the retiree can safely withdraw $24 000 ($600 000 x 0.04 = $24 000) in the first year, which is $2 000 ($24 000/12 = $2 000) per month in that year. Then, in subsequent years, the retiree can safely withdraw $24 000 adjusted for the prevailing inflation rate.
Say, the inflation rate is three per cent in the following year, then the retiree can safely have $24 720 ($24 000.00 x 1.03 = $24 720) in that year. In each subsequent year, the retiree can safely withdraw the $24 000 so adjusted for the prevailing rate of inflation during the year.
There is another rule of thumb called the “multiply by 25 rule” which serves to estimate how much you will need in your retirement funds to sustain your projected level of annual spending during retirement.
This rule says that you will need 25 times the projected annual spend. For example, if the retiree’s budget projects annual spending of $20 000, then $500 000 ($20 000 x 25 = $500 000) will be needed as a retirement fund to support such an annual amount being withdrawn from the fund each year.
The multiply by 25 rule assumes an overall annualised rate of return of four per cent. This is based on the assumptions of an inflation rate of three per cent per year and an annualised rate of return on stock and bond of seven per cent per year. These two interact to provide the four per cent (7-3=4) annualised rate of return for the retirement fund.
An adaptation of the multiply by 25 rule is the “multiply by 300 rule”. This provides an estimate of how much you will need in your retirement fund to sustain your projected level of monthly spending during retirement. For example, if you project that you will spend $2 000 per month in retirement,
$600 000 ($2 000 x 300 = $600 000) would be needed in your retirement fund. This rule is just a version of the multiply by 25 rule since 25 x 12 months = 300; the rule for the annual projection is so converted to a rule for a monthly projection.
The underlying assumptions of these rules are based on the historical performance of the stock and bonds markets and of the rate of inflation in the past. Looking forward to what appears to be a more unpredictable rate of return in the stock and bond markets, and likely more adverse market conditions, financial experts advise caution in the application of these rules.
The suggested amendments is to apply a three per cent rule in place of the four per cent rule, and multiply by 33 rule in place of the multiply by 25. Retirees need to assess the risks of applying any of these rules by examining the soundness and applicability of the assumptions for the rules as compared to their particular situation.
It is important to note that the multiply by 25 rule addresses the investment pool and income from your retirement fund. It does not take into account any other sources of retirement income. To the extent that there is income from other sources, the level of saving required in the retirement pool would be reduced.
• Louise Fairsave is a personal financial management adviser, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances. Email: [email protected].