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Retirement Planning > Saving for Retirement

The 4 percent solution?

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The main goal of retirement income planning is to help our money last as long as we do. This seems like a relatively straightforward objective, so why do so many people start with a retirement income strategy that leaves so much to chance?

The “4 percent rule,” which states that retirees can achieve a high probability that their savings will last 30 years by pulling about 4 percent annually from their nest egg and then increasing the withdrawn amount by 3 percent each year to offset the effects of inflation, has been a popular strategy since it was introduced in the early 1990s.

There’s no question that the 4 percent rule can be effective in helping to establish retirement budgets and spending patterns. But as we know, planning for retirement income doesn’t stop there. Analysis by Manoj Athavale in the Journal of Financial Planning (July 2011) has shown the 4 percent rule has an 18 percent probability of failure due to market volatility and longer life expectancies. In other words, 18 out of 100 people would run out of money in retirement utilizing the 4 percent rule. The shortcoming of this approach is evident in its lack of guarantees–an important factor when you consider the current historic level of market volatility. Further, it’s becoming increasingly apparent that the 4 percent rule, on its own, may not work for everyone.

Thankfully, solutions exist that can potentially increase income and can generate the same level of retirement income as using the 4 percent rule, but offer the added benefits of protection and guarantees.

Consider John, a hypothetical 60-year old who has worked hard to save money for retirement that begins at age 65.

After reviewing his estimated expenses and guaranteed sources of income (Social Security) in retirement, John and his financial professional determined that he would need an additional $10,000 annually to support his spending. Using the 4 percent rule, John would need $250,000 to generate that initial $10,000 ($250,000 x 4 percent = $10,000). John may want to have some protection for assets and income, making his future retirement income less vulnerable to market loss and/or longevity risk.

By utilizing a fixed indexed annuity (FIA) with an income benefit that may carry an additional charge as part of his retirement income plan, John may be able to generate the same $10,000 per year with far less in accumulated assets, while providing both protection from market loss and guaranteed lifetime income.

For John, this could mean starting at a withdrawal percentage from 5 percent to 7 percent. At the 7 percent rate, John would need only $142,857 to achieve the goal of $10,000 ($10,000/7 percent = $142,857). At 5 percent, he would need only $200,000 in initial assets ($10,000/5 percent = $200,000). Even better, John’s income can increase with income benefits that offer increasing income opportunities.

For people on the cusp of retirement, we financial professionals need to do better than fall back on the 4 percent rule when discussing retirement income with clients. It’s clear that the 4 percent strategy is only part of the discussion; more innovative solutions are necessary to deal with the significant risks that plague the retirement landscape. Increasing income options can help your clients manage the effects of market volatility and add a level of certainty for both their retirement assets and income.

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