The 4% rule has been a long-standing guideline for retirement income planning. It suggests that retirees can withdraw 4% of their savings in the first year, then adjust for inflation each following year, and have a high probability of not running out of money for at least 30 years. However, this rule has its limitations.
It assumes a specific asset allocation of 50% stocks and 50% bonds, and only applies to retirees around age 65. It also doesn’t integrate well with other income sources, potentially leading to inconsistent total income from year to year. The biggest drawback is that the 4% rule doesn’t adapt to changing circumstances.
If investment returns are higher or lower than expected, the withdrawal amount remains the same, which can lead to either running out of money prematurely or leaving money on the table. Consider a 62-year-old retiree, Mary-Helen, and her husband Joe. They have $800,000 in RRSPs and $200,000 in TFSAs.
Mary-Helen expects to live until at least 93. If their average annual investment return after fees is only 3%, they will deplete their savings by age 90, even with some pension and Old Age Security income.
Adapting retirement plans for flexibility
However, if they achieve 6% net returns for the first 10 years before dropping to 3%, their money would last longer. The 4% rule would give them the same income until 90 in both scenarios, showing its inflexibility. Using an algorithm, which is an online tool that calculates how much income can be withdrawn based on assumptions for investment returns, inflation, and life expectancy, can provide a more accurate estimate.
A sophisticated algorithm also factors in CPP and OAS pensions and the impact of starting these at different ages. This allows for adjustments based on actual performance and can potentially provide a higher income than the 4% rule. For Mary-Helen and Joe, an algorithm determined that starting CPP at age 70 was optimal, despite the slight reduction in their CPP amounts by waiting.
The algorithm can incorporate actual investment returns year by year, offering better precision. While an algorithm might assume a conservative 3% return, higher actual returns can be factored into future calculations. This flexibility reflects real-world conditions more accurately than the static 4% rule.
Examples of advanced algorithms include the Retirement Planning Calculator (Canadian), as well as calculators provided by many financial institutions. These tools can help retirees make more informed decisions and adapt their plans as circumstances change.
