Rules of thumb are common in financial literature. Who can disagree with “buy low, sell high” or “decrease your risk exposure by diversifying your portfolio”? Author and retirement planner Dana Anspach, CFP®, RMA®, observes that these kinds of rules of thumb can be useful to point the way, but beyond that, may lose their value. In her Great Courses series on retirement, she notes that if you want to go from New York to California, a valid rule of thumb is to head west. Once you have this direction in mind, however, you will need something more specific – a road map, atlas, or GPS – to get you to your desired destination.
Another concern is that some financial rules of thumb are more opinions and guesses; plus, some can be outdated or just plain wrong. They may send you in the wrong direction.
In the area of planning for your retirement, there are a number of rules of thumb that commonly appear in articles and seminars. Let’s test four of the more common guidelines to determine their worth in retirement planning.
Rule of Thumb 1: You will need 80 percent of your preretirement income to live on when you retire
This guideline has been around for decades, and it is showing its age. A key factor in this supposed 20 percent decrease in needed income is that once you retire, you will not have work expenses such as commuting and dressing for business. Obviously, this assumption is an anachronism for many. Another element in the 20 percent retirement income haircut is you will not be paying into Social Security and your mortgage will be paid off. The assumption that your mortgage will retire at the same time you do may be questionable. Some studies find the number of individuals who transition into retirement with a mortgage has nearly doubled in the last 30 years. However, the rule of thumb has some validity in that you may have a decreased need for income because you will cease contributing to your 401(k) plan. Whereas 30 years ago, employers were funding defined benefit plans for their employees, now most workers are funding their own retirement with 401(k) contributions. At retirement, that drain on your income would end.
The 80 percent rule has been fraught with issues since its inception because it ignores the dynamic spending patterns of most retirees. Early in retirement, many retirees will spend as much or more as they did in their working years. Much like the recent boom in travel hastened by the easing of the pandemic, these newly minted retirees feel free from their 9 to 5 work sentence, and they want to travel and enjoy their free time. This costs money. Conversely, once retirees are truly elderly, they are less likely to spend their retirement income on travel and entertainment and, barring unforeseen medical expenses, they will need less income. Targeting an across-the-board income goal of 80 percent of preretirement income when that retirement can last upwards of 30 years seems so inflexible as to be of little use.
Rule of Thumb 2: Your retirement should begin at age 65
This rule of thumb has little value other than as it relates to health insurance. Many prospective retirees, even those who are affluent, plan to put off retiring until they can lock in their medical insurance through Medicare at age 65. While this is a motivator to delay retirement, it should not be seen as a reason to accelerate retiring. There is no reason to stop working at 65 if you don’t want to. You can continue to work past age 65 and still be eligible to sign up for (and indeed you should sign up for) Medicare.
The age 65 rule of thumb is also losing meaning because retirement has become more of a process than an event. For many, the days of a retirement party, a gold watch, and trip to the rocking chair are gone. Retirement may mean leaving your career job but picking up part-time work. It is not uncommon to elect benefits such as Social Security and Medicare on dates that are different from your career retirement. For many, there is a blurred transition from employment to retirement. So, age 65 is just that – an age.
Rule of Thumb 3: Withdrawing four percent of your retirement savings each year will provide you with an income you will not outlive
This can indeed be a useful start towards addressing the “how much can I take each year” question – something that is often as misunderstood as it is quoted. Would-be experts talk of “the four percent rule” as a talisman that locks in a secure retirement. Unfortunately, there is no such quick fix to retirement planning, and its creator, Bill Bengen, never intended it to be used in this way. The basic idea of this rule of thumb is that if past market history is any indication (which is debatable), at age 65 you can take four percent of your retirement capital each year, adjusted for inflation, and not run out of money for at least 30 years. As a range to be thinking about, this is a useful starting point, but in some ways the exceptions swallow the rule.
First, the math behind this rule is based on past market performance, and it tells us nothing about what the future holds. Second, it is not intended to calculate the ideal amount to withdraw; it is meant as a minimum safe withdrawal. Depending on what year you retire and how the market performs going forward, strict adherence to this strategy could result in taking too little retirement income and unintentionally leaving a huge legacy to your heirs. And, perhaps what is most misunderstood about this rule of thumb is that it assumes a particular investment strategy – a strategy that includes having more than half of your retirement capital invested in equities. Some risk averse investors may not have the discipline or stomach to invest in this manner during retirement.
More recently, there have been concerns raised about the viability of using four percent as the bogey withdrawal rate. Some researchers feel under current conditions the target percentage rate should be lower. First, performance using four percent has not been tested in the more recent market cycles that include the tech bubble and the Great Recession. Further, persistently low bond yields have caused many planners to question whether taking four percent out of retirement savings makes sense when treasury bonds only yield half that amount. Finally, the ultimate question is whether this withdrawal rate is sustainable for a long enough period, specifically for the retiree’s lifetime. It has been over 25 years since this concept was first advocated, and during this period, life expectancies have increased. A 30-year retirement may no longer be a reasonable assumption to use in calculating a safe withdrawal rate.
Rule of Thumb 4: In retirement, you should hold a percentage of stocks equal to 100 minus your age
Some rules of thumb gain credibility because of the number of times they are repeated. The “100 minus your age” rule is right up there with “don’t go swimming for a half hour after you eat.” Just because it is quoted a lot doesn’t mean it’s right.
The basic idea behind this rule of thumb is that as you age, you should lower your exposure to equities because you will not have the luxury of waiting for the market to bounce back. Accordingly, says the rule, subtract your current age from 100 and, voila, you now know how much of your retirement capital should be invested in stocks. The trouble is that there is no foundation for the rule’s underlying principle. The amount of risk in your portfolio depends on other factors than your age. One’s typical retirement portfolio often includes fixed income from various sources - Social Security from the government, a pension from your employer, an individually purchased annuity. How much retirement income these sources generate will help determine how much risk you can take with your remaining retirement savings. In general, the move you have as a floor of locked-in retirement income, the more risk you can take with your remaining savings. And, this has nothing to do with 100 minus your age.
Another issue is that your legacy goals will play an important part in how much equity you should have in your retirement capital. If it is vital to you to leave a legacy when you’re gone, you will want to weight your savings heavier towards equities. Stocks have a better chance of keeping up with inflation, meaning over the long haul you will likely experience more long-term growth with equities than by leaving your savings in a certificate of deposit (CD). If you do not plan to leave a legacy, invest your money in annuities, and be done with portfolio management.
There are many drivers that affect how you should invest your retirement capital, but the difference between your age and the conveniently easy-to-remember number of “100” is not one of them.
In retirement planning, think of rules of thumb as easy to calculate guides that help you steer one way or another with your plans. They are basically a number-based form of a heuristic, using a mental shortcut to make a decision with minimal intellectual effort. And that’s ok – as long as the rule has a basis in truth and if it’s used as a beginning, not an end, to deciding the issue in question.
With this in mind, what about the four rules discussed above?
Rule 1: The rule of thumb that says you should target a retirement income that’s 80 percent of your preretirement income is dated. It played well when retirees had a defined benefit pension plan and stayed in their paid-for home for the remainder of their years. In today’s economy, this rule of thumb offers little guidance. A better approach would be to examine your current expenses and ask yourself which costs will remain in retirement and which will cease. Also, ask yourself the trajectory of your planned expenses. Will you have go-go years with higher expenses and then no-go years with reduced costs? Projecting these expenses will give you a better baseline for planning your retirement needs.
Rule 2: The magic retirement age of 65 was never particularly magic, and it certainly is not a required target for planning your retirement date. While it is the retirement age for Medicare (an important consideration), it is no longer the full retirement age for Social Security (think age 67 for most pre-retirees), and generally plays no part in calculating what you will receive from your defined contribution type plan. 401(k)s do not consider years of service; they deal with your contributions and how they’ve been invested. Far more useful in retirement planning is to assess your possible retirement income prospects at various ages, and then work backward to determine what age you can afford to retire. There are myriad retirement calculators that can make this process less painful than it sounds. These calculators become the new rule of thumb to use in your planning. In other words, start by entering your data into a retirement calculator to determine an approximate retirement age at which you can afford to retire. It may be 68; it may be 62; but it gives you a starting number.
Rule 3: Scholarly journals have long debated the virtues and problems with the “four percent rule.” The very volume of academic discussion on this topic supports the proposition that there is some merit to this overall rule of thumb. To the extent four percent is where you are beginning with your withdrawal strategy, be careful to fine-tune your approach along the retirement journey to reflect reality.
- Four percent may be less of a “for certain” number than it was in the past. That may be acceptable, but then what is your backup plan if markets perform poorly?
- How you invest your money will significantly affect the viability of this strategy. Be ready to maintain a balanced portfolio of equities and fixed investments.
- Consider adding guardrails and other techniques that will help you better weather volatile investment markets. You may need to make adjustments to your withdrawals during bad times. Think of four percent as a guide, not target.
Rule 4: Just because it is a catchy idea that 100 minus your age will tell you how much to invest in stocks does not make it true. Especially in a world where your retirement security is based on how you invest your retirement capital rather than the defined benefit that comes from your employer, asset allocation should be core to your retirement planning efforts. Forget the 100 minus your age rule of thumb and instead work to assure you have a solid investment strategy. Do your homework, get some help, and keep your plan up to date.
As a rule of thumb, these ideas will help assure a more secure retirement income.