A Fresh Perspective on Four Retirement Rules of Thumb

In the financial literature, there are a lot of rules of thumb. Who can argue with the adage "buy low, sell high" or "diversify your portfolio to reduce risk exposure"? According to author and retirement planner Dana Anspach, CFP®, RMA®, these kinds of thumb rules may be helpful to point the way. However, they may lose their meaning after that. In her Great Courses series on retirement, she mentions that heading west from New York to California is a valid rule of thumb. However, once you've decided on a route, you'll need something more precise to get you there, such as GPS, road map, or atlas.

Another issue is that several financial rules of thumb are more opinions or guesses; plus, some are obsolete or simply incorrect. They could lead you down the wrong path.

There are a variety of rules of thumb that often appear in articles and seminars about retirement planning. Let's put four of the most popular recommendations to the test to see how useful they are for retirement planning.

Rule of Thumb #1: After you retire, you'll need 80% of your pre-retirement income to live on.

This rule has been around for decades, and its age has started showing. One of the main factors in this alleged 20% reduction in required income is that after you retire, you will no longer have work expenses, such as commuting and business attire. For many people, this assumption is obviously outdated. Another part of the 20% retirement income cut is that you will not be paying for Social Security, and the mortgage will be paid off. It's possible that the presumption that your mortgage will be paid off at the same time you retire might be incorrect. According to some estimates, the number of people entering retirement with a mortgage has nearly doubled in the last 30 years. However, the rule of thumb holds some weight because you will no longer be contributing to your 401(k) account, which means you will have a lower need for income. Employers used to finance defined benefit plans for their workers, but now most employees fund their own retirement through 401(k) contributions. That drain on your income will stop once you retire.

As it ignores most retirees' dynamic spending, the 80 percent rule has been fraught with problems since its inception. Many retirees would spend as much as or more than they did during their working years when they first retire. These newly minted retirees, like the recent surge in travel prompted by the easing of the pandemic, feel liberated from their 9-to-5 work schedules and want to travel and enjoy their free time. That costs money. In contrast, once retirees are really elderly, they are less likely to spend their retirement money on travel and entertainment, and they may need less income, barring unexpected medical expenses. When a retirement can last up to 30 years, aiming for an overall income target of 80% of pre-retirement income seems inflexible and not very useful.

Rule of Thumb #2: You should retire at age 65

This rule of thumb is only useful in the context of health insurance. Even the wealthiest seniors plan to delay retirement so they can lock in their medical benefits via Medicare at the age of 65. Although this is an incentive to postpone retirement, it should not be construed as a justification to retire sooner. If you don't want to, there's no need to quit working at 65. You can continue working after the age of 65 and still be eligible for (and should sign up for) Medicare.

The 65-year-old rule of thumb is also losing relevance, as retirement has evolved into being a process rather than an event. The days of a retirement party, a new watch, and a trip to the rocking chair are long gone for many people. Retirement can be leaving your full-time job but taking on part-time work. It's not unusual for people to choose benefits like Social Security and Medicare on dates other than their work retirement. For many people, the line between work and retirement is blurred. So, 65 is just that: a number.

Rule of Thumb #3: Withdrawing 4% of your retirement savings per year would provide you with a steady stream of income that you won't outlive.

That can be a good place to start when answering the question of "how much can I take each year" – which is as often quoted as it is misunderstood. Aspiring experts tout "the four percent rule" as a talisman for securing a comfortable retirement. Unfortunately, there’s no simple fix when it comes to retirement planning, and Bill Bengen, its creator, never intended for it to be used like this. The basic principle behind this rule of thumb is that if the past market experience is any indicator (which is debatable), you can withdraw 4% from your retirement account annually, adjusted for inflation, and still have money for at least 30 years if you start at age 65. This is a good set to think about as a starting point, but the exceptions in some ways overshadow the norm.

To begin with – the math behind this rule is based on past market results and provides little insight into what the future holds. Second, it is not supposed to be used to determine the optimal amount to withdraw; rather, it should be used as a minimum safe withdrawal. Depending on when you retire and how the market performs in the future, sticking to this strategy too closely could result in taking too little income in retirement and unintentionally leaving a substantial legacy to your heirs. Perhaps the most overlooked aspect of this rule of thumb is that it assumes a specific investment policy – one in which you have more than half of your retirement funds invested in equities. Some risk-averse investors may lack the discipline or stomach to invest like this in retirement.

More recently, questions have been posed about the feasibility of using 4% as a bogey withdrawal rate. According to some experts, the target percentage rate should be lower under current conditions. First, in recent market cycles, such as the tech bubble and the Great Recession, success using four percent has not been checked. Furthermore, with bond yields consistently low, many financial planners are questioning whether taking 4% out of retirement accounts makes sense when treasury bonds pay just half that. But the most important question is whether this withdrawal rate can be sustained for a period that’s long enough, particularly for the retiree's lifetime. It's been over 25 years since this term was first proposed, and life expectancies have risen during that period. When calculating a secure withdrawal rate, a 30-year retirement might no longer be a realistic assumption.

Rule of Thumb #4: You should have a percentage of stocks equal to 100 minus your age when you retire

The number of times a rule of thumb is said, the more credible it becomes. The “hundred minus your age" rule is right up there with the "do not go swimming for a half-hour after you eat" rule. It doesn't mean it's right only because it's often quoted.

The basic principle behind this rule of thumb is that when you get older, you should reduce your exposure to equities because you might not live to see the market recover. As a result, this rule says, deduct your current age from 100, and you'll know how much of your retirement funds should be invested in stocks. The problem is that the underlying theory of this rule has no foundation. Your portfolio's risk level is determined by factors other than your age. Fixed income from different sources, such as Social Security from the government, a pension from your employer, and an individually acquired annuity, is common in a traditional retirement portfolio. The amount of retirement income you will get from these sources can help you decide how much risk you will take with your remaining retirement funds. In general, the more locked-in retirement income you have as a base, the more risk you will take with your remaining savings. And it has nothing to do with the ‘100 minus your age’ rule.

Another problem is that your legacy objectives will have an important role when deciding the amount of equity you should have in your retirement capital. If leaving a legacy is important to you, you can allocate a larger portion of your savings to equities. Stocks have a greater chance of keeping up with inflation, so you'll definitely see more long-term growth with them than you will with a certificate of deposit (CD). If you don't want to leave a legacy, put your money in annuities and say goodbye to portfolio management.

There are many factors that determine the way you should invest your retirement funds. However, the difference between the conveniently easy-to-remember number 100 and your age is not one of them.


Bottom Line

Think of rules of thumb in retirement planning as easy-to-calculate guidelines that help you steer your plans in the right direction. They're essentially a numerically dependent heuristic that uses a mental shortcut to decide with minimal cognitive effort. And that's fine for as long as the rule is founded in reality and is applied as a starting point rather than a conclusion in resolving the problem at hand.

So about the four rules mentioned above? 

Rule 1: The 80 percent rule of thumb, which states that you should aim for a retirement income that is 80% of your pre-retirement income, is out of date. When retirees used to have a defined benefit pension package and lived in their paid-for home for the rest of their lives, it worked well. This rule of thumb doesn’t provide much guidance in today's economy. A better strategy will be to look at the current expenditures and determine which ones will continue in retirement and which will be eliminated. Also, consider the course of your anticipated expenses. Will there be go-go years with higher costs followed by no-go years with lower costs? When you project these costs, you'll have a better idea of what you'll need in retirement.

Rule 2: The magic retirement age of 65 has never been especially magical, and it is certainly not a requirement for determining when to retire. Although it is the Medicare qualifying age (an important consideration), it is no longer the maximum retirement age for Social Security (think age 67 for most pre-retirees) and has little bearing on how much money you will earn from your defined benefit plan. Years of service aren't taken into account in 401(k)s; instead, they focus on the contributions and how they've been invested. Assessing your potential retirement-income opportunities at different ages and then working backward to ascertain what age you can afford to retire is much more useful in retirement planning. There are plenty of retirement calculators available to make the process easier than it seems. These calculators will become the latest retirement planning rule of thumb. To put it another way, begin by plugging your information into a retirement calculator to figure out when you'll be able to afford to retire. It may be 67 or 61, but it gives you a starting point.

Rule 3: Scholarly publications have long discussed the benefits and drawbacks of the "4% rule." The sheer amount of scholarly debate on the subject supports the idea that this general rule of thumb has some validity. If your withdrawal strategy starts at 4%, be sure to fine-tune it as you progress through retirement to reflect reality.

– Four percent might be less of a “sure thing” than it has been in the past. That might be acceptable, but what happens if markets do not perform well?

– How you spend your money would have a huge impact on the strategy's feasibility. Prepare to preserve a well-balanced equity and fixed-income portfolio.

– Consider implementing guardrails and other strategies to help you properly navigate unpredictable financial markets. During difficult times, you might need to adjust your withdrawals. Think of 4% as a guideline rather than a goal.

Rule 4: The argument that 100 minus your age would tell you how much to invest in stocks isn't real just because it's a catchy one. Asset allocation should be at the heart of your retirement planning activities, particularly in a world where your retirement security is determined by how you spend your retirement capital rather than the fixed benefit provided by your employer. Instead of using the 100-minus-your-age rule of thumb, make sure you have a good investment plan. Do your research, seek assistance, and keep your strategy up-to-date.

As a rule of thumb, these suggestions will assist in ensuring a more secure retirement income.

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