Why These Three Retirement Rules of Thumb Are Bad Ideas

By Chip Castille | May 27, 2014 AAA

What makes a good rule of thumb? It should be memorable, pithy and, above all, useful. It also shouldn’t overreach; it just gives good guidance. “Measure twice, cut once” is a great example. It doesn’t try to explain carpentry. It just reminds us to take our time, be precise and avoid making a mistake that can’t be undone. (Not bad for four words.)

What makes a bad rule of thumb? How about this: it doesn’t work. Or worse, it brings about exactly the opposite of what you intended. Retirement is full of advice that sound reasonable but may be bad for your retirement health. Here are three to be wary of:

Rule of Thumb #1: Save 3% of Salary for Retirement

The most frequent auto-deferral rate into a 401(k) is 3% of pay, probably because it typically maxes out the company match. Unfortunately, 3% is just not going to get the job done.

Think of it this way: you will likely work for about 40 years and retirement can last up to 30. That means 40 years of pay checks need to be spread across 70 years. Common sense suggests that 3% (even with a company match) is not going to be enough provide the spending you’d like once you’re in retirement.

Our recent research suggests that 10 to 13% is more reasonable. If that sounds like a lot, think of it this way: paying your future self 13% of your current pay can buy you 30 years of retirement spending. It may actually be a bargain.

Rule of Thumb #2: The 4% Drawdown

Let’s say you retire with one million dollars in savings. One of the most common rules of thumb is that the first year you should withdraw 4%, or $40,000. Next year, add a cost of living adjustment, say 2.5%, and take out $41,000. And so on.

The risk here is that if the market moves against you, the odds increase that a rigid withdrawal plan will increase the odds of running out of money. If the market rallies, the opposite can happen and you will leave behind a large unspent surplus. (Great for your heirs, of course, but you would have enjoyed retirement less than you could have.)

So what’s a better rule of thumb? Probably one based on a dynamic amount, a percentage of your portfolio. You may have less to spend some years, and more others, but the risk of spending down your assets is substantially reduced. What’s more, as you get older and have a shorter retirement period to fund, you can increase the percentage.

 

Rule of Thumb #3: 120 minus Your Age

We know that it makes sense to have a more conservative portfolio as you get older. This Rule says the equity percentage in your portfolio should be 120%, minus your current age. So a 60 year old should have 60% equity while a 75 year old should have 45%. We can quibble over the percentage, but this sounds reasonable, right?

Well, no. And here’s why. Let’s say the 60 year old is retired and the 70 year old is healthy, happy, still working and plans on working until 75. The 70 year old can actually tolerate more risk than the 60 year old because she has five years of future wages to grow her assets and offset market loses. The 60 year old has no more future wages to offset losses and may feel that 60% equity is too high.

This idea of factoring future wage potential into the allocation is actually what some investment strategies do, and why a 30 year old (with 35 years of wages ahead of him) has more equity exposure than a 60 year old with only five years of human capital left.

 

Chip Castille, Managing Director, is head of the BlackRock US Retirement Group. You can find more of his posts here.

Investing involves risk including loss of principal.

Investopedia and BlackRock have or may have had an advertising relationship, either directly or indirectly. This post is not paid for or sponsored by BlackRock, and is separate from any advertising partnership that may exist between the companies. The views reflected within are solely those of BlackRock and their Authors.

You May Also Like

Related Articles
  1. Is an online adviser right for you? As with most questions in financial planning, the answer is 'it depends.' Here are a few thoughts to consider.
    Professionals

    Is An Online Financial Advisor Right ...

  2. Something you can do for your savings and investing resolutions this year is to rely on tools already available at your workplace and take them to the max.
    Savings

    Taking Smaller And More Manageable Resolutions

  3. Get Rich Slowly found about the insights on investing from about 2,000 selected individuals by an online survey. Do they have an investing strategy?
    Investing Basics

    Do You Have An Investing Strategy?

  4. It can be great to live in the moment, but the actions and decisions you make now can greatly impact your sense of financial security down the road.
    Personal Finance

    How Do Americans Keep Minimizing Their ...

  5. You don't need to be a Gucci to afford to retire in Italy, but saving money means finding a less-traveled spot. Start by exploring these beautiful locales.
    Retirement

    The Top Places For Retiring in Italy ...

Trading Center