Sometimes Rules Are Meant to Be Broken
Allocating money to plan for tomorrow yet live for today is difficult. In my opinion, it’s human nature to look for quickly learned and applied rules of thumbs to help us achieve our goals. As I see it, we face one big problem; one size does not fit all. I believe it is essential to understand each guideline and the reasons behind them and make sure that you do not blindly follow, or you could fall short or cheat yourself out of new life experiences.
Subtract your age from 100 to determine how much you should invest in equity investments
One of the most widely accepted principles of investing is to gradually reduce your risk as you get older with the understanding that as you age, you have less time to ride out market volatility. A common rule of thumb simplifies figuring out how much equity you should have in your portfolio. It states that individuals should hold a percentage of stock equal to 100 minus their age. As an example, a typical 60 years old should have 40% stock exposure. The remaining 60% would comprise of high-quality bonds and cash equivalents.
While this rule of thumb simplifies creating an asset allocation, I believe it completely ignores a few things that are normal for today’s retirees. First off, people are living longer than they used to. According to the Social Security Administration, the average life expectancy of a 65-year-old male is around 84 years old, it is slightly higher, at 86.5 for a female. Not only will we need additional money during retirement to compensate for longevity, but we also have more time to recover from market volatility and the potential to try to grow our money to offset inflation.
At the same time, bonds are paying a fraction of what they once did. Some of you may remember that in the early ’80s, investors could count on interest rates of 10% or more. That is a pretty stark comparison with today’s current interest rate environment of less than 1%. Even in a half-million-dollar portfolio, a 60% allocation to high-quality bonds and cash equivalents, earning 1% would only make $3,000 on an annual basis. Hardly enough to generate a luxury lifestyle.
Instead of subtracting your age from 100, we think it is far better to consider your cash needs, life expectancy, and risk tolerance in determining how you should invest.
You will need 70-80% of pre-retirement income to live on when you retire
One of the many questions surrounding retirement is how much annual retirement income will I need? I often hear professionals provide estimates ranging from 70%-80% of pre-retirement income to maintain the same standard of living. The idea behind the rule is that there are expenses that you will leave behind as you leave your job. For example, you will probably pay less for gas without having to commute to work and pay less on your wardrobe if you no longer need spiffy work attire. You also will not be making contributions to your retirement account or withholding for Social Security and Medicare taxes. Based on the maximum limits for 2020, if you were maxing out your 401k contribution, that is an immediate $26,000 savings alone. You can see that you can quickly move beyond the guideline.
Sure, the common thread in dreaming of retirement includes freedom, enjoyment, and stress-free living. However, if you ask five different people what that means to them, you will get at least five different answers. Today’s retirement is a lot different than my grandmas. Times have changed, and now many intend to make the most of our remaining years by living life to the fullest. How you choose to live out those retirement dreams, we believe, will dictate how much income you will need in retirement a lot more than the guideline suggesting that 70-80% of pre-retirement income is average.
You can safely take 4% of your retirement portfolio annually
A well-known retirement rule of thumb is commonly known as the 4% rule. Based on a 20-year retirement period, the guideline suggests it is highly likely that you can remove 4% of your portfolio without having to worry about running out of money. While this is a quick way to estimate, it doesn’t consider your specific longevity and the timing of your withdrawals.
Let’s say time is most likely not on your side. Are you worried about stretching your assets over 20 years, or enjoying life to its fullest? 4% could be cheating you out of enjoyment. In contrast, if longevity is realistic, maybe 20 years isn’t a reasonable period, and you need to be concerned about stretching your portfolio over 30 years and adjusting to a 3% withdraw rate.
Given the recent volatility in our markets, I probably don’t have to remind you that markets go through periods of good and bad times. It is not just the markets that we have to worry about, but also the timing of our withdrawals, especially during those bad times. Many people are not able or willing to reduce distributions during market downturns. They end up taking over 4%, and ultimately the withdrawals, and possibly the timing of those distributions will harm the likelihood of having enough to last through retirement. Quite the opposite can be true in good markets, increasing the amount you withdraw may be a good idea as long as you are not risking your portfolio’s longevity.
Rules of thumb are a good starting point for thinking about your situation. Understanding if they apply, given your circumstances, is another story. Easily applied rules of thumb can’t take into account your unique situation and therefore, may not provide you with answers that suit your situation. If in doubt, be sure to discuss your unique situation with a CERTIFIED FINANCIAL PLANNER™ professional who can help you review the financial guidelines.
This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.