People love shortcuts. The world of financial advice is no exception. The field is rife with quick and easy ways to do everything, from estimating your income in retirement to picking the ratio of stocks to bonds in your portfolio. The ubiquity of these rules of thumb isn’t necessarily a bad thing, as some guidance is usually better than none. However, some rules of thumb are so inaccurate or sub-optimal that they should be done away with entirely. Here are three of them:
The 4% rule
The thought of outliving your assets is frightening, and this fear sends many people looking for a maximum “safe” withdrawal rate. Enter the 4% rule. It states that you should withdraw 4% of your total portfolio value in your first year of retirement, then withdraw that same dollar amount, adjusted for inflation, every year after that. Coined in 1996 by financial planner William Bengen, it is based on the historical fact that, from 1926 to 1976, a 60% stock and 40% bond portfolio following this strategy would have always lasted at least 33 years.
This rule of thumb has already received its fair share of criticism, most of it focused on the rule’s inaccuracy in low interest rate and investment return environments. While valid, this critique misses the 4% rule’s most fundamental flaw: it frames withdrawal rates in entirely the wrong way.
How much you withdraw shouldn’t be decided by an arbitrary percentage of your portfolio, but by your ability to meet your current and future expenses. Figuring this out can be complicated, but it’s worth it: make a list of your desired spending goals, consider the income you’ll have in retirement, model out how much you’ll have to withdraw to meet your goals throughout retirement, then (if necessary) cut goals until you reach a sustainable withdrawal rate.
100 minus your age
This rule of thumb is so pervasive that versions of it are embedded in the investment management strategy of billions of dollars in target date funds. The rule goes like this: to reduce the risk of having to swallow large investment losses in retirement (when you don’t have time to save more or otherwise course correct), gradually reduce your stock exposure as you get older so that it equals a percentage of 100 minus your age.
This approach is way too conservative. According to Morningstar data, in the period of 1926-2015, stocks have outperformed bonds an average of 99% over a 30-year period, 83% over a 10-year period, and 71% over a 5-year period. If you follow this rule, you’re sacrificing massive potential returns for slightly less volatility on investments that you’re not selling until (in most cases) much later.
What’s a good alternative? Invest based on your goals, not your age. Figure out your liabilities in retirement and split them into categories based on necessity and time horizon. For essentials like your housing costs, take a more conservative approach. For a stretch goal like that trip to Europe, be a bit more aggressive. And for expenses like medical costs, which you’re likely to incur much later in retirement, take a moderate amount of risk.
This rule – you’ll likely need 80% of your pre-retirement income to maintain your lifestyle in retirement – is rooted in the idea that your expenses will drop off significantly for age-related reasons around the time of your retirement. Your mortgage will end, your kids will move out, you don’t need to continue saving and your tax rate may fall.
But people’s spending needs in retirement vary greatly, and 80% isn’t an accurate estimate for most people. In a 2015 paper, the Employee Benefit Research Institute found that in the first two years of retirement, 46% of households spend more than they spent in the two years before retirement while only 39% spent less. Further, recent research from United Income indicates that spending volatility increases with age, making the static 80% rule even less reliable for older households.
To get an accurate picture of your post-retirement expenses, you’ll have to sit down and, item-by-item, think about exactly what your spending needs in retirement will be. This might be significantly more complex, but the payoff is large. You’ll be able to more accurately set your pre-retirement savings rate, and you can rest easy knowing you won’t face the sticker shock felt by most retirees when they realize the 80% rule has led them astray.
The key to replacing rules of thumb: technology
The three rules of thumb above are popular for two reasons: they’re easy, and the better alternative (personalization) is seen as too time consuming or too expensive. Fortunately, advancements in financial planning technology in the last 20 years have made personalized financial planning vastly easier and cheaper. Rather than relying on the 80% rule, new technology gives people the opportunity to see how others like them (in income, location, demographics, etc.) have spent throughout retirement, giving them an idea of how their own spending needs might evolve. As for the 100-minus your age rule, digital investment managers now allow consumers to assign different risk tolerances to different pools of money, allowing for infinite customization. Computer simulations can tell someone the odds of a particular withdrawal strategy depleting a portfolio over the course of 40 years, making the 4% rule obsolete. These advancements represent a sea change in the availability of quality of financial planning. Consumers should take advantage of them and retire these retirement rules of thumb.