Money

Understand the ‘4% rule’ and why you must drawdown your super

Superannuation nest eggs can be complex and subject to weird rules and regulations, including drawdown rules. Nigel Bowen busts the myths on retirement planning and explains Australia’s drawdown rules.

By Nigel Bowen

People who take an interest in wealth-building and retirement sometimes pay heed to two classic - and most likely outdated rules - one is the ‘4% rule’ and the other is the ‘25x rule’.

Both rules appear all over the internet, having been born out of American financial planning circles, and parroted by endless free (and not always trustworthy) retirement planning articles on the web.

These rules go something like this:

The 25x rule - applies to how much you need to save to retire

Once you save up 25 times your annual living expenses, you have enough money to retire. So say you spend $50,000 to ‘survive’ each year, you need 25 x $50,000 in your nest egg - $1,250,000. This ‘nest egg’ then provides you with an income in retirement, when you no longer have a salary paid to you by an employer or your business.

(PS: This rule doesn't really apply in Australia, where we have a combined superannuation and Age Pension retirement income system - but you should read Citro’s Calculating Retirement Guide to work out how much you need to retire.)

The 4% rule - how much of your nest egg you drawdown once retired

Withdrawing 4% of your retirement nest egg each year usually results in it lasting 30 years or so. Following the 4% rule means you should withdraw a maximum of $50,000 per year ($1,250,000 X 4%) to cover your living expenses.

As with most retirement-income calculations, the details soon get convoluted due to variable things like inflation and purchasing power.

These 2 rules don't really apply in Australia

The Retirement Standard issued each quarter by the Association of Superannuation Funds of Australia (ASFA) says Australians who own their own home need less than this mythical $1,250,000 nest egg.

ASFA says a couple with a superannuation balance of $690,000 combined by the age of 67 can earn a comfortable retirement income of $71,723.56 per year.

A single with a superannuation balance of $595,000 by the age of 67 can earn a comfortable retirement income of $50,981.27 per year.

For those with less stashed in super, a modest retirement income can be had with just a $100,000 nest egg so couples can earn $46,620.05 while single retirees can earn $32,417.48.

This is because Australia’s Age Pension system will still deliver a part Age Pension. There's even a Peak Pension opportunity for those who don't have quite enough stashed in super.

What about retirement planning rules in Australia?

Australia has a very different retirement income system to America, Britain and even our close neighbours New Zealand.

We have compulsory superannuation, which means most of us will retire with some level of money above the Age Pension. 

While most 67-year-olds today rely on a part or full Age Pension, more of us in the future will self-fund our retirement through a mix of superannuation and investments outside of super.

That means we need to understand more about superannuation and what we can do with it.

One of those rules we need to come to grips with is ‘drawdown rules’, which mean people who stop officially retire must draw down a proportion of their super balance every year.

The good news is that these drawdown requirements are reasonable. They are also broadly in line with what’s commonly referred to as ‘the 4% rule’.

The drawdown rules and retiring in Australia

You need to reach preservation age - usually 60 - and begin ‘de-accumulating’ your superannuation to officially retire.

It’s not advisable, but if you want to take out all your super money as a lump sum and blow it all during a week in Las Vegas, you can. 

There are rules for how much super you must ‘cash in’ or drawdown on once you turn your super into a pension.

The current minimum drawdown rate for those who’ve retired, or semi-retired, after reaching preservation age is 4%. 

That jumps to 5% for those aged 65-74, 6% for 75-79, 7% for 80-84, 9% for 85-89 and 90-94 for 11%. If you make it to 95, you’ll have to spend 14% of whatever super money you have left every year you continue to soldier on.

What you can’t do is leave all your money in your lightly taxed super account to hoard and not spend.

Super is designed to be drawn down and spent so that you don’t become a drain on the public purse.

You can leave your super money to your kids or heirs, especially if it turns out you’re not around for very long, but you are required to deduct a proportion of it every 12 months.

Whether by accident or design, these rates hew closely to the 4% rule mentioned at the top of this story, with the bulk of retirees only being required to withdraw 4%-7% of their retirement nest egg each year.

You can actually draw down more, should you wish, but most of us are too worried about outliving our retirement savings so we don’t do it.

The drawdown rates are set by the Federal Government, which considers the views of academics, industry experts and other stakeholders. (Ones with access to comprehensive data about older Australians' average incomes, expenses and super balances.) 

That noted, few of us are entirely average. 

For instance, while the average Australian aged in their late 60s may be able to live comfortably on 4% of their super balance per annum, many may choose to withdraw a much larger percentage one year to fund overseas travel, pay off their mortgage, or get renovations done.    

Planning for the unknowable  

One day, we may all know precisely how long we will live. Until that day dawns, everybody involved in Australia’s super system, not least retirees, must deal with the fact human lifespans vary.

It’s possible to calculate averages. But it remains the case that you could retire today and fall under a bus tomorrow. Or live to be 110. 

Even in retirement, many Australians will continue to be bedevilled by that eternal question – do I splurge and have a good time now or live frugally so I’ll have money if I need it down the track?  Read more on how to make your retirement income last as long as you do.

Most retirees choose a middle path. 

They may, for instance, treat themselves to a round-the-world cruise early in their retirement but avoid any other significant expenses after that blowout. 

It’s these ‘middle of the road’ types who are likely to worry most over withdrawing too much or too little.

Why you’re unlikely to “run out of money” in Australia

The final factor to consider with drawdowns is the size of your super balance.

Compulsory superannuation has only been around for a few decades. That means many of us might only have a modest super balance, or none at all if we've been self-employed.

If you’ve only got, for instance, a super balance of $150,000, there’s little point trying to exist on the minimum drawdown of $7,500 a year after retiring. Better to read and understand Peak Pension so you can maximise your savings before your retire and enjoy a decent income over your retired life. You can also read the 12 benefits and concessions Australians should claim, as well as understand what your free Medicare card offers.

While many Australians, especially those most impacted by the switch from Age Pensions to compulsory superannuation, worry about being reduced to penury in retirement, these concerns are almost always unjustified.

The issue successive federal governments have been growing increasingly concerned about isn’t retired Australians running out of super money. It’s that they are failing to make use of it when they should and leaving substantial sums to their heirs. 

To be clear, this is not the norm. But as has been widely reported, it’s common enough for both sides of politics to now be contemplating making “wealthy ageing baby boomers who have large super funds and valuable property” make a greater contribution to their aged care costs.

Governments continue to provide for the much larger number of older Australians who have exhausted a meagre super balance or who never accrued one in the first place. 

In fact, you don’t even have to have used up all your super money to qualify for a part-age pension, you just need to meet the income test and assets test. Read more on Age Pension 101.

To summarise, if you haven’t been worrying about drawdown rates, you should continue to remain unconcerned.

If you have been worrying, you should rest assured you still have a lot of control over when you spend your nest egg and total control over how you spend it.

For now, at least.

Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.

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