What is the 4% rule?
The 4 percent rule is a simple way for people in retirement to manage the way they draw their income from their accumulated pension funds every year. In theory, it allows them to keep a steady stream of income whilst also maintaining an adequate amount of funds that can be used to provide an income in future years, and for the rest of their lives. It takes into account assumptions of how your invested pension funds could continue to grow over time, even when you are drawing funds out, based on historic bond and stock returns.
The way the 4% rule works is that in the year of retirement, you calculate 4% of the balance of your pension funds and then withdraw that amount in £’s as an income. Each subsequent year, you take the previous years’ £ value and then adjust it for inflation, and then take out that amount in £’s. This should then allow your income to continue to be paid for the next 30 years, which should hopefully be sufficient to provide you with an income for the rest of your life.
Where did the 4% rule come from?
The 4% rule is also known as the Bengen rule, named after the aeronautical engineer turned financial adviser William Bengen who devised the rule in the early 1990’s. The rule simplifies the many complexities that can be considered when planning for drawing an income in retirement.
What are the advantages and disadvantages to the 4% rule?
There are various pros and cons of the 4% rule, and this is due to the conditions it requires to be relevant.
An easy to follow guideline
The main advantage of the 4% rule is the simplicity of the calculation in working out how much you can draw from your pensions in retirement and allowing future funds to be available for future income.
A consistent income
Because it is a fixed amount and easy to adhere to, you can plan for a consistent income come retirement. This can give you peace of mind, but also helps you to plan for the long-term.
Stops you running out of money early
Your money will last for much longer because you have spread out the funds available to you.
There are disadvantages of the 4% rule, however:
No guarantees
Although the 4% rule can make it more likely that your funds will last you for your remaining lifetime, it does not guarantee this. The rule is based on the past performance of both markets and pension funds that are linked to markets and will not predict what will happen in the future.
Pension fund value may erode
A severe or prolonged downturn in stock markets could cause the value of pension funds that are linked to them to erode quicker than is usual, reducing the overall amount of pension funds that can be used to provide an income in retirement. The effect of this would be that the pension funds could run out earlier in retirement.
Be wary of withdrawing lump sums
Should you wish to take more income in a specific year (and/or a lump sum to pay for say a large value holiday or a new car), this can also have consequences later in life because your pension funds may run out quicker than planned.
Does the 4% rule still work?
It is said that the 4% rule is a little conservative and really, a 5% calculation should be used instead (so your initial income is 5% of the value of your accumulated retirement funds at the start of your retirement). Some commentators say that a 3% calculation is more realistic, especially when growth in stock markets is low and when inflation is high, such as we are seeing in today’s world.
How Lovewell Blake can help you create a retirement plan
For the majority of people, planning for retirement and managing pension income and savings in retirement is a balancing act.
When planning for retirement, it is all about trying to set aside sufficient funds to use in retirement whilst still leaving sufficient funds available to pay for everyday life and specific events that could occur.
During retirement, it is all about trying to best manage the accumulated funds you have to make sure they will allow you to fund a good lifestyle and provide you with sufficient income that will last for your lifetime.
The 4% rule is a simple way to help you to manage your accumulated pension funds during retirement.
However, the best way to ensure that you are currently on track to accumulate sufficient funds for the retirement you wish for, and also ensure that you have sufficient funds that will last for your lifetime, is to seek specialist financial advice from an Independent Financial Adviser.
At Lovewell Blake, following an initial assessment of your current financial position and an in-depth discussion on how you would like your retirement to look, we can provide you with a detailed financial plan that will allow you to fulfil the retirement that you wish for. We will then be on hand to review your plan on a regular basis to ensure you remain on track.
Lovewell Blake are experienced chartered accountants who can offer individuals and families a range of tax planning services, including personal estate planning assistance.