Retirement planning can feel overwhelming, especially with the abundance of advice available. Some rules of thumb can be helpful starting points, but others may lead you astray. Here, we’ll debunk five popular financial guidelines that could potentially derail your retirement plans.
1. The “10 Times Your Income by 67” Rule
One common rule of thumb suggests that by age 67, you should have ten times your income saved. For example, if you’re earning $100,000 annually, this rule implies you should have $1 million in your retirement portfolio. While this might work for some, it can be a misleading and potentially dangerous guideline.
The primary issue with this rule is that it conflates income with spending. How much you earn and how much you spend are entirely different matters. Additionally, your retirement income likely won’t rely solely on your portfolio.
Consider two individuals, both earning $100,000 at age 67. The first spends $80,000 per year and has only Social Security as non-portfolio income, while the second spends $60,000 annually but also has a pension in addition to Social Security. The first person might need $1.25 million in their portfolio to support their retirement, while the second might only need $250,000. If you were to apply the ten-times-income rule indiscriminately, you might end up either under-saving or over-saving, depending on your unique circumstances. Over-saving might seem like a lesser problem, but it could lead to unnecessary sacrifices or a delayed retirement.
2. The “Save 10-15% of Your Income” Rule
Another widely accepted rule of thumb is the notion that you should save 10-15% of your income for retirement. While it’s better to save something rather than nothing, this rule doesn’t account for individual circumstances, especially the age at which you begin saving.
Let’s compare a 25-year-old and a 55-year-old, both earning $100,000 per year and saving 10% of their income. Both aim to retire at 65. Given the power of compound interest, the 25-year-old will accumulate significantly more than the 55-year-old by the time they retire. The younger saver could end up with $2.6 million, while the older saver might only have $145,000.
This rule of thumb may serve as a rough guideline early in your career but becomes less relevant as retirement approaches. Depending on your situation, it could lead to either excessive saving or insufficient saving. A personalized savings strategy, tailored to your specific goals and timeline, is essential.
3. The “4% Withdrawal Rule”
The 4% rule is a cornerstone of retirement planning, suggesting that you can safely withdraw 4% of your retirement savings annually without running out of money. While this rule was groundbreaking when introduced over 30 years ago, it has limitations that can pose risks to your financial security.
The 4% rule is based on the assumption of retiring into the worst-case market scenario, using historical data as a guide. If you retire into a favorable market, you may end up with significantly more money than you started with, potentially missing out on experiences or opportunities because of overly cautious spending. Conversely, if you encounter a prolonged market downturn early in retirement, sticking rigidly to the 4% rule could jeopardize your financial stability.
A more dynamic, personalized approach to withdrawals, which considers market conditions, your spending needs, and other factors, can help you optimize your retirement income while minimizing risks.
4. The “Average 10% Market Return” Assumption
It’s a well-known fact that the U.S. stock market has historically averaged a 10% annual return. However, relying on this average when planning your retirement can be misleading due to the significant variability in market returns.
The S&P 500, for instance, has seen single-year returns as high as 54% and as low as -43%. The average return is 10%, but markets never deliver this average consistently. The sequence of returns—whether you experience good years or bad years early in your retirement—can have a profound impact on your financial security. If you encounter a significant downturn early on, your portfolio could suffer long-term damage, even if the overall average return aligns with historical norms.
Instead of relying solely on the average return, it’s crucial to plan for market volatility and adjust your strategy accordingly. This might involve setting aside a cash reserve or adjusting your withdrawal rate based on market performance.
5. The “Subtract Your Age from 100” Rule
This rule suggests that your age subtracted from 100 should determine the percentage of your portfolio in stocks. For example, if you’re 55 years old, 45% of your portfolio should be in stocks and 55% in bonds. Another variation starts with 120 instead of 100, keeping a higher stock allocation for longer.
The issue with this rule is that it oversimplifies the complex relationship between risk and time horizon. It assumes stocks are inherently risky and bonds are safe, which leads to a more conservative portfolio as you age. While this approach might reduce short-term volatility, it can expose you to a different kind of risk: the erosion of purchasing power due to inflation.
Over a 30-year retirement, inflation can significantly reduce your purchasing power. Historically, stocks have provided higher returns than bonds when adjusted for inflation, making them a crucial component of long-term growth in your portfolio. While it’s important to have safe, stable investments, overly conservative allocations could result in your portfolio not keeping up with inflation, thereby reducing your standard of living in later years.
These financial rules of thumb were designed to simplify the complex world of retirement planning. While they can serve as helpful guidelines, they should not be the sole basis for your retirement strategy. Instead, consider your unique financial situation, spending needs, and market conditions when planning for retirement. A personalized approach tailored to your specific circumstances is often the best way to ensure a secure and fulfilling retirement.