As a financial columnist, I get asked the same heartfelt question over and over: “How do I make sure I don’t outlive my money?” And that makes sense. Surveys confirm that the No. 1 worry among older Americans is running out of cash. Fortunately, financial planners have come up with sound ways to prevent this. Collected here are their key rules for maintaining a livable income for life, plus case studies that show how to put these general rules into action. The goal is your peace of mind — knowing that you’re getting the most from the money you’ve saved and that you’ll always have enough.
The Magic Number
The key to long-term planning is knowing one essential number: how much money you can afford to spend annually. From there, you can adjust your expenses to fit.
You may be tempted to reverse the order — estimate your future expenses, then adjust your investment assumptions to make that spending appear possible. But that’s wishful thinking: a hope that big investment returns will rescue your budget. It leads to overspending early on, and regret later.
Instead, let’s focus on the real, guaranteed money you’ll have. There are two main sources:
- Your personal savings and investments.
- Your guaranteed income from other sources.
Download this worksheet to help you find your sustainable income. The key steps:
Step 1: Tally Your Guaranteed Income
The most common source is Social Security, which you may already be collecting. (If you’re not, get an estimate by calling Social Security or by opening a My Social Security account at ssa.gov.) You might also have a pension or annuity. If you own a reliable rental property, include the amount of rent you receive after expenses.
Step 2: Estimate Your Income from Savings
How much annual income can you prudently take from your savings and investments? To get the answer, there’s a surprisingly simple rule of thumb:
- Add up the current value of your spendable assets, such as bank accounts, mutual funds, stocks and bonds. Include both retirement and nonretirement savings.
- Subtract from that total a cash cushion to help cover near-term expenses.
- Then take 4 percent of what remains.
That’s the “safe” amount of your assets that financial planners say you can afford to spend in the first year of retirement without running the risk that your savings will run out. In each subsequent year, take the same dollar amount plus an increase for inflation.
Example: Say you have $100,000 invested (plus a cash cushion). In the first year of retirement you could spend $4,000 of that money. If inflation is running at 3 percent, your second-year withdrawal would be $4,120 — the first-year amount plus an inflation increase. Follow this pattern in each future year.
Under this system, known as the “4 percent rule,” your savings should last at least 30 years and probably more. That forecast is based on the pioneering work of planner William Bengen, who tested 30-year spending rates against the historical returns of U.S. stocks and Treasury bonds. Some years the markets are up and some years they’re down, but the 4 percent rule takes that into account. As long as you keep withdrawing a steady amount of money, plus increases for inflation, you won’t run out. This rule would have protected your annual income even during 30-year periods that included the Great Depression of the 1930s and Great Stagflation of the 1970s. In better periods, savings lasted for many years more.
Step 3: Total Your Income
Add that “safe” 4 percent amount to your annual guaranteed income. For example, if you’re due $20,000 from Social Security and take $4,000 from a $100,000 nest egg, you’ll have $24,000 that you can safely use for living expenses, including any taxes.
Step 4: Set Your Budget
Finally, divide your expected yearly income by 12 to get your available monthly cash. And that’s it. Don’t worry about inflation; your income should keep up with inflation, thanks to Social Security’s cost-of-living increases and the annual increases you take from savings.
Calculate your spendable income three ways: once as a couple, once assuming that you die first, and once assuming that your spouse dies first. Don’t skip this analysis! Couples generally get two Social Security checks — one per spouse. The survivor will get only one. If you get a pension, it, too, might go down or go away when you die. Each spouse should know what might change after the other’s death.
Worried that these numbers won’t fund a decent standard of living? You might want to tap your home equity.
Home equity loans, however, can be hard for retirees to get. Instead, if you want to stay put, you might get a reverse mortgage: a loan against your home with no payments due until you leave it permanently. The debt is usually settled via proceeds from your home’s sale. Costs are high: If your house is worth $260,500 — the median U.S. price — a $50,000 credit line might carry $13,000 in one-time fees. (That money comes from your home equity, not your pocket.) Another option: Take in a renter. Or you could downsize, adding your home-sale proceeds to your investments.
The 4 percent rule rests on the premise that you invest about half of your nest egg in low-cost funds — index mutual funds or exchange-traded funds — that hold big-company stocks and track the market’s moves. The other half is in Treasury bond funds. If you also hold funds with smaller stocks, Bengen says it’s safe to start at 4.5 percent.
If you avoid stocks, however, and own only bonds and CDs, 4 percent is too high. Your initial safe withdrawal rate is more like 3 percent, says economist Wade Pfau of the American College of Financial Services in Bryn Mawr, Pa. You might also start with that number if you retire early or own individual stocks, which are riskier than market-tracking mutual funds.
On the other hand, you might go higher. The original 4 percent rule was designed to protect you from the worst of times, says financial planner Jonathan Guyton of Edina, Minn. But most 30-year periods do just fine, and you might find that you’re skimping while money piles up. Guyton suggests starting with 5 or 5.5 percent. But do that, he says, only if you have at least 60 percent of your investments in stocks and you’re willing to cut back a little — say, 10 percent of your planned annual withdrawal — when markets fall. Five percent also makes sense if you want only 20 years of income — for example, if you don’t quit work until you turn 75.
Jane Bryant Quinn is a personal finance expert and the author of How to Make Your Money Last: The Indispensable Retirement Guide. She has been a contributor to AARP since 2006.