3 Retirement Rules of Thumb That Actually Work
We’re always told not to rely on rules of thumb for retirement planning. They’re too general, have too many exceptions and produce less-than-optimal results. All of which is true. And yet, rules of thumb can also be helpful, especially if the alternative is not planning at all or getting too fancy and botching things up.
In an ideal world, we would all take a long hard look at our finances, rigorously project our estimated lifetime earnings so we know precisely how much we need to save each year to maintain our standard of living in retirement and then figure out the mix of stocks and bonds that provides the returns we need to grow our savings adequately without exceeding our tolerance for risk. And, of course, we’d faithfully monitor our progress and periodically repeat this process and make occasional adjustments along the way.
But we don’t live in an ideal world. We live in a world that abounds with unknowns, where a volatile and unpredictable market makes forecasting extremely difficult and, perhaps most important, where retirement planning competes for our time, attention and financial resources with many other obligations (holding down a job, paying bills, raising a family). Which means many people simply aren’t going to devote to retirement planning the time and attention it deserves.
If you are one of those people, here are three rules of thumb that, while far from perfect, can at least give you a shot at a secure retirement. And on the off chance you find yourself up for ways to improve your retirement prospects once you’ve got your planning underway, I’ve also suggested a way to improve on each rule of thumb.
1. Save 15% a year. It’s impossible to know exactly how much you must sock away in retirement accounts each year to have a reasonable chance of maintaining your standard of living retirement. But 15% of salary a year is a pretty decent target. Indeed, a recent Boston College Center for Retirement Research report cited 15% of income as the amount that the typical household should save. And in his book Your Money Ratios: 8 Simple Tools For Financial Security, Northstar Investment Advisors’ Charles Farrell recommends 15% annually, at least initially.
That 15% figure, by the way, includes any employer matching funds you may receive by contributing to a 401(k) or similar retirement account. So you may not have to get to 15% on your own.
How to Improve on This Rule: One problem with the 15% benchmark is that if you get a late start on saving, even 15% a year may leave you with a smaller nest egg than you’ll need. Also, the percentage of income you need to save can vary considerably depending on what sort of lifestyle you want to live in retirement, not to mention how much you earn during your career. High earners, for example, typically have to save more than people with lower incomes because Social Security will replace a smaller percentage of their pre-retirement income. You can get a more accurate fix on how much you should save by going to a tool like the Will You Have Enough to Retire? calculator in RDR’s Retirement Toolbox. If you do that periodically and, if necessary, adjust the amount you save, you should be able to stay on track toward a comfortable retirement.
2. Create a portfolio based on your age. To figure out what percentage of your retirement savings should be in stocks, simply subtract your age from 100. So if you’re 25, you would keep 75% of your savings in stocks. If you’re 50, you would invest 50% in equities, and when you’re 75, that percentage would decline to 25%. The rest goes into bonds.
The premise behind this rule is that when you’re young, your primary focus should be on earning high long-term returns, which the stock market has historically delivered over the long term. You shouldn’t be too concerned about market setbacks, as you’ve got plenty of time to recoup short-term losses. As you near and enter retirement and begin looking to your portfolio to provide regular income, your focus shifts more toward protecting your savings. So you’ll likely want a more conservative investment portfolio that will be more stable. For example, while a portfolio of 75% stocks and 25% bonds would have declined 26.5% in the financial crisis year of 2008 when stocks got hammered, a more conservative mix of 25% stocks and 75% bonds would have lost only 5.4%.
How to Improve on This Rule: The major shortcoming of this rule is that not everyone of the same age has the same tolerance for risk. Some 25-year-olds might be more cautious than others and prefer a less stock-intensive portfolio. And some 75-year-olds might be willing to accept a higher level of volatility than others. Also, in addition to risk you also need to consider potential return. While you may find a more conservative stocks-bonds mix more emotionally appealing, it might not provide the returns you’ll need to build an adequate nest egg. To find a stocks-bonds mix that provides a reasonable balance between risk and return, fill out this Investor Questionnaire.
3. Start with the 4% rule. Pulling enough money from your nest egg to give you sufficient income while not withdrawing so much that you’ll deplete your savings too soon is one of the major challenges retirees face. And over the years, advisers and academics have come up with a variety of ways to address this issue. But if you’re looking for a very simple method, start with the 4% rule—that is, the first year of retirement withdrawal 4% of your total retirement savings, and then increase that dollar amount by the inflation rate each year to maintain purchasing power. So, if you have $500,000 in all your retirement accounts, you would withdraw $20,000 the first year of retirement. If inflation is running at 2% a year, you would increase that $20,000 to $20,400 the next year, $20,800 the next, etc. By following this rule, you should have a relatively high level of assurance—generally an 80% or so chance—that your savings will last 30 or more years.
How to Improve on This Rule: This rule of thumb is perhaps the most controversial of the three, for good reason. For one thing, the premise is that you want your money to last 30 or more years. I think that’s a reasonable assumption for many people retiring at 65. But if you’re retiring at 70 or later, you may not need your money to last 30 years, and you can start with a more generous initial draw.
And even though the chances of your money running out following the 4% rule are relatively low, there’s no guarantee your dough will last. In fact, you could deplete your nest egg much sooner than 30 years, especially if your investments incur losses early in retirement. There’s also another risk: If your investments do well, sticking to the rule could leave you sitting on a big pile of savings late in life. That might not sound like a risk, but it could mean that you unnecessarily stinted early in retirement when you could have spent more freely and enjoyed yourself more.
So while the 4% rule can be a reasonable starting point for withdrawals when you retire, you definitely do not want to follow it blindly. You’ll want to be flexible and maintain the ability to shift your spending up or down based on your needs, your age and how much savings you have left. You can do that by going each year to a good retirement income calculator, plugging in the size of your nest egg, your planned withdrawal and the number of years you want your savings to support you. The calculator will then estimate the probability that your nest egg will last. Based on that estimate, you can then increase or decrease your planned withdrawal.
Bottom line: A rule of thumb can’t address all the complexities of real life. But following a good one is better than just winging it, and ideally may lead you do more nuanced planning down the road. (10/24/14)
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question on retirement or investing that you would like Walter to answer online, send it to him at firstname.lastname@example.org.