How can retirees avoid running out of money? The 3% rule is a common guideline, but in years of extreme inflation or poor investment returns, this rule of thumb might not make much sense. Here’s a look at retirement money management strategies that go beyond the 3% rule.
What Is the 3% Rule?
First things first – what exactly is the 3% rule?
In retirement planning, the 3% rule refers to the safe withdrawal rate (SWR) method in which retirees withdraw 3% of their retirement funds each year, with adjustments to account for inflation. In some variations of the safe withdrawal rate rule, retirees may withdraw another percentage, such as 4% in the 4% rule. However, it is always a small percentage, and this is a fairly conservative strategy that is intended to help retirees avoid outliving their money.
Let’s say you have $1 million in a retirement fund. If you withdraw 3%, you’ll be taking out $30,000. If inflation increases by 2%, you can increase your withdrawal accordingly, so you’ll take out $30,200 the next year.
The Pros and Cons of the 3% Rule in Retirement Planning
The 3% rule can give you an idea of how much money you can safely withdraw each year. This can help with retirement planning and budgeting. For example, if you expect to have $1 million in retirement savings and you think $30,000 will be enough each year when combined with other sources of money like Social Security retirement benefits, you may decide that you’re fine to retire. If this is not enough, you may decide you need to work longer and save more or else downsize your retirement plans and make do on less.
If your funds grow sufficiently year after year due to investments, you may be able to withdraw 3% each year without losing any money because you’ll be living off your investment earnings while leaving your principal intact. However, if your portfolio does not grow enough to make up both your withdrawals and inflation, your total funds will slowly deplete until you run out of money. This may not be a problem. Because you’re making conservative withdrawals, you should still have enough money for quite a while.
The downside is that it’s impossible to predict inflation and investment returns. If your investments perform very poorly or inflation rates are very high, you may end up running out of money much faster than you anticipated. On the other hand, if your investments perform well and inflation is controlled, you may end up with a lot of money left, and you could regret living so frugally when you could have been enjoying your golden years.
Another problem is that the 3% rule is very rigid. It may not work if your expenses are higher than expected one year, for example, because you have health problems or because you decide to splurge on a vacation.
How to Adjust When the 3% Rule Doesn’t Pan Out
If the 3% rule doesn’t work due to high inflation, poor investment returns or unexpected expenses, you have other options.
- Adjust your withdrawal strategy. You may decide you need to adjust your withdrawals each year in response to economic factors, tax burdens and personal needs. However, it’s important to make sure you’re not overspending.
- Find a new source of income. Many retirees end up going back to work, often on a part-time or consultant basis. While this may be done for economic reasons, it can also be attractive to people who find their work to be very rewarding.
- Leverage alternative retirement planning strategies. Lifetime annuities have become a popular option for retirees who want a retirement income source. However, there are different types of annuities, and they can involve fees and penalties for early withdrawals, so make sure you understand the fine print before you decide.
Allocating Retirement Income Between Spending Categories?
When you calculate how much you’ll need for retirement, you need to consider how you’ll be spending your money. Underestimating your costs in one category can throw off your entire retirement spending strategy.
Healthcare expenses are a prime example. Many people underestimate how much they’ll spend on healthcare during retirement because they think Medicare will cover everything. However, seniors have to pay premiums, deductibles, and copays, and these costs can add up. Additionally, some costs – including most long-term are costs – aren’t covered.
Create a realistic budget for your retirement expenses, including:
- Housing (monthly rent/mortgage, home/renters insurance, renovations, maintenance, property tax)
- Utilities (energy, water, phone, internet, etc.)
- Food (groceries and dining out)
- Transportation (car payments, auto insurance, maintenance or bus and cab costs)
- Healthcare (health, dental, hearing and vision insurance premiums and out-of-pocket costs)
- Long-Term Care (home health aides, nursing home care, etc.)
- Other Insurance (life, funeral, long-term care, etc.)
- Shopping (clothes, electronics, household items, etc.)
- Entertainment
- Hobbies
- Travel
- Family (gifts or support for kids or grandchildren)
- Income Tax
- Other
If your costs add up to more than your withdrawals and income, you need to rethink your retirement strategy.
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