Comparing the 7 Percent and 4 Percent Retirement Rules?

know the rules of money managementRetirement planning is all about making sure your savings will last for the rest of your life. Two key strategies often discussed are the seven percent rule and the four percent rule. These rules are designed to help you figure out how much money you can withdraw from your savings each year without running out of funds. However, they differ in a significant way: the seven percent rule ignores inflation, while the four percent rule factors it in.

Let’s explore both strategies, breaking down their advantages and drawbacks. Let’s also look at how inflation can impact your retirement. We’ll share the stories of Emma and John, a couple who have their finances in order, and Sarah and Mike, who often confuse wants with needs, to illustrate how these rules play out in real life.

The Basics of the Seven Percent Rule

The seven percent rule suggests you can withdraw up to seven percent of your retirement savings each year without depleting your funds too quickly. It assumes that your investments will earn a high enough return to sustain these withdrawals over time. The seven percent rule is often used by those looking for higher income in the early years of retirement. This rule carries significant risks, especially because inflation isn’t factored in.

How It Works

Imagine you have $500,000 saved for retirement. Using the seven percent rule, you would withdraw $35,000 per year (seven percent of your savings). This allows you to access a higher income in the short term. The challenge is ensuring your investments keep growing to replenish what you take out.

Since this rule ignores inflation, it assumes the cost of living remains stable. In reality, prices for goods and services tend to rise over time, so this approach could lead to a shortfall in later years if your savings don’t keep pace with rising expenses. This could work especially well for you, if you are in danger of being in the OAS clawback area.

The Basics of the Four Percent Rule

The four percent rule, on the other hand, is a more conservative approach. It suggests that you can safely withdraw four percent of your retirement savings each year and still have enough to last for 30 years or more. This rule factors in inflation, which means it’s designed to ensure your savings retain their purchasing power over time.

How It Works

Let’s say you have $500,000 saved for retirement. According to the four percent rule, you would withdraw $20,000 in your first year. Then, in each subsequent year, you would adjust that amount based on the rate of inflation. For example, if inflation is two percent, you would increase your withdrawal to $20,400 in the second year.

The four percent rule is built on the idea that your investments will grow steadily. But it also assumes you’ll need more money in the future to keep up with rising costs. By accounting for inflation, this rule aims to provide long-term financial security. This may not work especially well if you are in danger of being in the OAS clawback area.

Inflation: The Silent Threat to Retirement

InflationInflation is the gradual increase in prices over time, and it’s a big factor in retirement planning. While two percent inflation might not seem like a lot, it can significantly erode your purchasing power over a long retirement. If you ignore inflation, you may find that your savings don’t stretch as far as you expected.

For instance, if you’re following the seven percent rule and withdrawing the same $35,000 every year without adjustments, you’ll have less buying power as prices rise. That $35,000 may cover your needs in year one, but by year 10 or 20, it could feel like much less.

The four percent rule accounts for this by increasing your withdrawals over time to match inflation. It’s a way to protect your lifestyle as the cost of living goes up, helping ensure your money lasts for the long haul.

Emma and John: Sensible Living with the Four Percent Rule

Emma and John are a sensible couple who have always managed their money carefully. They started saving early, living within their means, and consistently contributing to their retirement accounts. When they began planning for retirement, they looked at both the seven percent and four percent rules.

Emma and John’s Financial Snapshot:

  • Retirement savings: $600,000
  • Withdrawal rate: four percent, adjusted for inflation

They chose the four percent rule because they wanted a plan that would last for the long term. Emma and John know that their savings need to stretch for 30 years or more, and they want to protect themselves from the effects of inflation.

In their first year of retirement, they withdrew $24,000 (four percent of $600,000). As inflation increased by two percent the next year, they adjusted their withdrawal to $24,480. By sticking to this conservative strategy, they’re confident they won’t run out of money and will be able to maintain their current lifestyle.

Sarah and Mike: Risky Living with the seven Percent Rule

Sarah and Mike are a different story. They’ve struggled with their finances, often confusing wants with needs and living beyond their means. They didn’t start saving for retirement until later in life and didn’t contribute regularly. When it came time to plan their retirement, they were drawn to the seven percent rule because it allowed them to withdraw more money upfront.

Sarah and Mike’s Financial Snapshot:

  • Retirement savings: $400,000
  • Withdrawal rate: seven percent, not adjusted for inflation

Sarah and Mike liked the idea of withdrawing $28,000 per year (seven percent of $400,000), as it gave them more spending money in the early years of retirement. However, they didn’t consider how inflation would impact their expenses. After several years of withdrawing the same amount, they started to feel the pinch. Prices for everything from groceries to healthcare had gone up, but their income stayed the same.

out of moneyAs a result, Sarah and Mike began to worry they might run out of money sooner than expected. They didn’t plan for inflation. Now they’re facing tough choices about cutting back on their lifestyle or finding other sources of income in their retirement years.

How to Choose Between the Seven Percent and Four Percent Rules

So, which rule should you follow? The answer depends on your personal financial situation, goals, and risk tolerance. Here are a few things to consider when deciding between the seven percent and four percent rules:

  • 1. Your Risk Tolerance
  • The seven percent rule offers a higher withdrawal rate but comes with more risk, especially if your investments don’t perform well or inflation rises faster than expected.

  • The four percent rule is more conservative, providing a steady income stream that’s adjusted for inflation. It’s a better choice if you want long-term security and lower risk.
  • 2. Your Investment Strategy
  • If you have a diversified portfolio and are comfortable with market volatility, the seven percent rule might work for you. However, you’ll need to monitor your investments closely and be prepared to adjust if necessary.

  • The four percent rule is ideal for those with a more balanced, less aggressive investment strategy. It assumes steady growth over time, which aligns with long-term financial security.
  • Read about why David chose ETFs for his retirement fund – Why Diversified ETFs Are Your Best Bet in the Long-Term

  • 3. Your Time Horizon
  • If you’re planning for a long retirement (20+ years), the four percent rule is likely the safer option. It’s designed to last for at least 30 years and takes inflation into account, which is crucial for maintaining your standard of living.

  • The seven percent rule might be suitable for those expecting a shorter retirement or who are comfortable taking on more risk in the early years.
  • 4. Your Spending Habits
  • Are you more like Emma and John, who live within their means and budget carefully? The four percent rule will provide you with a stable, predictable income throughout retirement.

  • Or are you more like Sarah and Mike, who tend to confuse wants with needs and spend more freely? While the seven percent rule might seem attractive because it allows for more spending upfront, it carries the risk of running out of money too soon.

The Impact of Inflation on Retirement

Let’s take a closer look at how inflation affects retirement savings. Even a modest inflation rate of two percent can have a significant impact on your purchasing power over time. If your annual expenses are $40,000 today, they could rise to over $49,000 in just 10 years with two percent inflation.

For those following the seven percent rule, this could mean struggling to keep up with rising costs, especially if you’re withdrawing the same amount each year. The four percent rule, by contrast, is designed to account for inflation, adjusting your withdrawals annually to maintain your buying power.

Emma and John’s Smart Strategy

By choosing the four percent rule, Emma and John are better prepared for the future. They know that even as prices rise, their income will adjust to meet their needs. They don’t have to worry about outliving their savings or making drastic changes to their lifestyle in later years.

Sarah and Mike’s Struggles

Sarah and Mike, on the other hand, are starting to feel the consequences of ignoring inflation. They’re stuck withdrawing the same amount each year, while the cost of living continues to rise. Without enough income to cover their expenses, they’re facing difficult decisions about cutting back or finding additional sources of income in their retirement years.

Key Takeaways

Here’s a quick recap of the differences between the seven percent and four percent rules, and how they factor in inflation:

  • Seven Percent Rule:
  • Higher initial withdrawals, but ignores inflation. This rule is riskier and could result in running out of money if inflation rises or investments don’t perform well.

  • Four Percent Rule:
  • More conservative, increases to adjust for inflation, and is designed to last 30 years or more. It’s a safer choice for long-term financial security.

Emma and John’s story shows the power of sensible planning, while Sarah and Mike’s experience highlights the risks of overlooking inflation. By understanding the impact of inflation and choosing the right withdrawal strategy, you can create a retirement plan that protects your financial future.

Planning for retirement is about more than just saving; it’s about making sure your money lasts as long as you do. Whether you choose the seven percent or four percent rule, the most important thing is to understand the risks and rewards of each approach. With careful planning and a strategy that accounts for inflation, you’ll be well on your way to a secure and comfortable retirement.

Note: I have ignored the CPP and OAS amounts to make things simpler. In Canada, we can expect to receive CPP based on our lifetime income, and OAS, as long as our income remains below the maximum income threshold. As of 2024, the Maximum CPP at age 65 is $1,364.60 per month, and the Maximum OAS is $718.33 per month, for a combined annual total of 24,995.16. You must meet a number of criteria to obtain the maximum from each. The CRA provides a lot of information in this article – Main sources of retirement income.

Disclaimer for ManageYourMoney.ca

The information provided on ManageYourMoney.ca is intended for educational and informational purposes only. It should not be taken as financial advice. The opinions shared are those of the authors and are meant to encourage sensible financial habits and decision-making. We recommend that you do your own research or consult a certified financial advisor before making any financial or investment decisions. All investments come with risks, and there is no guarantee of success. Past performance is not a reliable indicator of future results. Always consider your personal financial situation and risk tolerance before pursuing any investment opportunities.

As always, I am not a qualified financial advisor. I just relate financial management to my own experience which may not resemble yours at all. Advice is frequently worth exactly what you paid for it. Most of mine came from expensive experiences.

Please share your thoughts in the comment section below.

Leave a comment

Verified by MonsterInsights