Financial Planning Rules of Thumb: Do These Old Guidelines Actually Work?
Financial Planning Rules of Thumb: Do These Old Guidelines Actually Work?
The money world is full of financial planning “rules of thumb” that are supposed to make retirement planning easier. You’ve probably heard of some of these:
- The 4% Rule for withdrawing from your retirement nest egg
- The 60/40 Rule for splitting investments between stocks and bonds
- The Wait Until You’re 70 Rule regarding Social Security
- The 80% Rule for determining retirement income needs
Do these work? Are they age-old wisdom that doesn’t get stale? Or are they shortcuts that are past their due date?
The Appeal of the Cookie-Cutter
We’ll explain each common financial planning rule of thumb below so you can get a sense of how they work. But here’s the problem: planning your financial future on a rule of thumb leaves you very vulnerable. That’s because they were designed to make things easy.
But easy and accurate are two different things. That’s why we don’t use these rules of thumb, and neither should you.
There’s just too much risk in applying a cookie-cutter solution to plan your future. It may work, but it may not, and you do not want to find out at age 85 that your financial planning was not on track. Or, on the flip side, why follow some general rule of thumb that limits your spending more than it needs to? Life is meant to be enjoyed, but following an arbitrary rule could really restrict your fun.
Let’s take a look at each rule because there is some value to learning how each evolved.
THE 4% RULE FOR RETIREMENT PLANNING
Probably the best known of these financial planning rules of thumb is the 4% rule. This so-called rule helps solve a big problem: helping retired people know how much they can safely withdraw from their savings each year. The goal of this rule is to provide an income stream while at the same time providing a high level of certainty that your money will last for at least 30 years. [i]
Where Did the 4% Rule Originate?
This rule, unlike some of the others, actually has a documented history grounded in analysis. Over 25 years ago, William Bengen, a former aeronautics engineer turned financial advisor, was fed up with the complexity of retirement planning. He wanted to find a better way. So he analyzed 50 years of historical data on stock and bond returns. He discovered that no case existed based on that 50 years (from 1926 to 1976) where retirees would have exhausted their funds in less than 33 years by keeping to a 4% annual withdrawal rate. [ii]
William called this rule SafeMax, and after publishing it, its use spread like wildfire in an industry looking for a more straightforward solution. Along the way, the name evolved into the 4% rule, but it is still well-known today as a retirement planning technique.
Does the 4% Rule Still Work?
The 4% rule is easy to understand. You just limit your annual withdrawals in retirement to 4% of your nest egg. Later years are then adjusted for inflation. The rule also assumes you hold a portfolio made up of 50% stocks and 50% bonds.
The allure? Simplicity. It is easy to implement and track. However, like many things in life, the devil is in the details.
Yes, the 4% rule was based on 50 years of market data, but there is no guarantee the next 50 years will be anything like that time. With stocks having provided stellar returns for the past decade, it is possible that returns may be lower than expected going forward. Possibly a lot lower…and of course, no one has a crystal ball.
At the same time, inflation is rising after decades of flat-lining.
Then there are other concerns. This rule was developed based on data from when bonds and CDs provided reasonable yields. With that no longer the case, you’re likely counting on a volatile stock market for more of your financial security. Finally, life expectancies are higher than they were during the period studied.
These factors could make the 4% rule downright dangerous for some folks.
For others who may have more in savings, the 4% rule might do the opposite: create self-imposed austerity when it’s not even needed.
After all, most people don’t spend the same amount year in and year out. Instead, you may have years you travel more, or buy a boat. The 4% rule does not have the flexibility to account for that.
Other areas that it doesn’t accommodate:
- If you have an influx of cash for investment during retirement, often from a home sale, inheritance or sale of another asset, that should in theory allow you to take over 4%, but the rule doesn’t adjust.
- Many retirees spend more early on, but then scale back as they become less interested in long trips, etc. While we frequently plan for clients to take more from their accounts early on, this rule doesn’t allow for that.
By relying on the rule, you may be setting yourself up for lifestyle limitations that may not even be needed.
What Should You Use Instead of the 4% Rule?
That’s why we recommend developing your retirement income strategy based on your actual financial plan, not an arbitrary rule of thumb. That way, you’ll have more certainty that your money will last, and you can enjoy your retired life.
THE 60/40 RULE FOR RETIREMENT PLANNING
So let’s move on to the next rule of thumb. This one is sometimes called the 60/40 portfolio. Or other times, it’s simply a reference that you should hold a percentage of stocks equal to 100 minus your age in retirement. The remainder would be bonds or fixed income.
This one does not have such a clear history, but regardless, it has good staying power. It has been repeated for decades.
The rule implies that you should gradually lower your exposure to stocks as you age since you don’t have the time to make back significant losses.
Does the 60/40 Retirement Rule Work?
Like our previous example, yes, there might be times when this just happens to be spot on. Maybe. The trouble is that there is a whole lot is riding on your decision. In this case, there is little foundation for this rule…there is no study it is based on.
In reality, the amount of risk you take should be based on many other factors aside from your age. Because two people the same age can have starkly different financial situations. In fact, two identical twins can have totally different circumstances. One may have saved all their life and remained disciplined in spending. In contrast, the other may have spent recklessly and ended up with little put away for retirement. Age is just one of many measures.
The 60/40 Rule also doesn’t consider your starting point and what income you have from other sources: social security, a pension from an employer, maybe an annuity or two. Generally, the more fixed income sources you have, the more risk you can take with your retirement savings. But if you don’t have that pension and annuity, you may need to reel in the risk. None of this is known by asking your age.
Then, this almost random number doesn’t consider your goals in leaving a legacy behind. If you intend on leaving money for family or charities, you may want to increase your risk and hold more equities.
Doesn’t Factor in Today’s Unique Risks
Right now there’s even a more important consideration. We often see clients who haven’t saved enough to weather what we consider today’s biggest potential threats:
- Persistent/lasting inflation
- High medical bills as they age
- Rising interest rates
Following this rule could put them in danger. Rising interest rates especially could cause losses that people aren’t necessarily expecting. We’ve all watched bond prices rise over the past years as interest rates have dropped to generational low levels. Eventually that trend will reverse, and when it does, bond prices will go the other way: down. (People will not want to hold low-interest bonds since new bonds will pay higher rates.) That process could severely impact the percentage of your portfolio help in bonds. The risk boils down to this: what seems most “safe”—hiding out in fixed income—could be the riskiest move of all.
Bottom line, retirement planning today is complex and involves many moving parts. Simplifying it to just your age is almost like gambling. Yes, it may turn out just fine, but do you really want to wait 30 years to see if you were right?
There are better ways to plan your future with so much at stake.
THE “WAIT TILL 70” RULE FOR SOCIAL SECURITY
There’s another rule of thumb with Social Security, and that’s to always wait until you are 70 years old to file. That way, you will get the maximum benefit.
There is definitely a lot to like about this rule. If you can wait, you get a bigger social security check. Not just one time…for the rest of your life.
That said, it doesn’t always mean it is right for you. Again, the devil is in the details:
- Your health. If you have a family history or health condition that might mean a shorter life expectancy, it might make sense to file earlier.
- Your tax situation. Depending upon your other sources of income, your Social Security checks may be taxed at up to 85% of the benefit. However, if you’re withdrawing from a pre-tax retirement account, that could be 100% taxable as income. You might get more mileage by leaving your retirement account invested and taking Social Security early.
There are other circumstances to consider. Let’s say you are forced to retire early and didn’t save enough. In that case, getting the supplemental Social Security income earlier might prevent you from using up too much of your life’s savings too soon.
So, as you can see, this rule of thumb is similar to the others. Sometimes it works great, but not always.
THE 80% RULE
Another often-repeated rule says you’ll need 80% of your preretirement income during retirement. (Or some people may say 70%.)
I think by now, you notice a pattern….sometimes, these might magically fit you, but probably not. Yes, some people might just spend 80% of their preretirement income in retirement. But that’s purely a guess. Why?
Let’s think about it. Working full time and the associated commute may have consumed 40, 50, 60 hours or more in a week. How you fill that time is up to you, but many people start new hobbies, travel more or try new activities. Those all cost money and can quickly increase your expenses.
We have some clients who have doubled or tripled their travel expenses in retirement. And why not? You deserve to spend your money the way you want. But the 80% rule might stop you from doing that, which to me is really sad. Nothing makes me as a financial planner happier than helping people achieve their lifelong goals. It would be tragic if some arbitrary “rule” prevented someone from doing what they want to do if they can afford it.
Or sometimes spending can increase in other ways that are not so pleasant. Your healthcare costs could jump in retirement. Sometimes it’s due to advancing health problems. Or, it might be rising insurance costs as you strive to fill the gap between retirement and age 65 (when Medicare starts).
Also, your tax deductions will often decline in retirement. That’s because you will usually have fewer dependents, no or lower mortgage expenses, and no 401(k) deductions. So many times, you’ll find your taxes going up too.
All of these things lead to higher spending, not lower.
On the income side, you might even see an increase there. This can happen when you have a pension or high required minimum withdrawals from your retirement accounts combined with Social Security.
As you can see, these so-called financial planning rules of thumb are actually more like guesses. While they are not bad as a general starting point, relying on them might either open you up to risks or limit your ability to enjoy life in retirement.
Even William Bengen, who is now retired, seems to agree that these old rules may not hold up today. [iii]
Instead, you should give yourself the benefit of customized financial planning so you get an answer you feel confident about. You’re unique, so your retirement plan should reflect that. Your retirement planning must consider your goals, finances, timelines, and risk tolerances. Your future is too important for anything less.
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