Retirement planning can get complicated, so we often fall back on rules of thumb, or “heuristics” as economists call them. That approach may work sometimes—and is certainly better than doing nothing—but it can be dangerous too. Here’s what you need to know about four largely-but-not-completely true tenets of retirement planning.
1. Save 10% a year and you’ll be fine. The appeal of this oft-repeated precept is that 10% is a nice round number that’s achievable for many people. And stashing away 10% of your salary may very well lead to a secure retirement—if you start doing so in your early 20s and never miss a year for the next 40 years.
Problem is, many of us don’t get as early a start on our savings effort as we’d like. Indeed, when researchers for TIAA-Cref asked pre-retirees last year what they wished they’d done differently to prepare for retirement, 52% said they wished they’d started saving sooner. And even if you do get that early start, any number of unforeseen events—a layoff, an illness or injury, an unexpected expense—may prevent you from sticking to your regimen, or even force you to dip into your retirement savings.
Considering that many of us may get a late start or run into disruptions along way, a better strategy is to shoot for a higher savings target, say, 15%, more if possible. That will give you a little wiggle room in case you fall short some years. Better yet, rev up a good retirement calculator periodically, and plug in the amount you have saved and the amount you’re setting aside each year to see whether you’re doing enough. Making small adjustments as early as possible will spare you from having little choice but to save at a painfully high rate late in your career in order to achieve a secure retirement.
2. Your spending drops dramatically in retirement. The problem with this statement is that it might be true—or it might not. The consensus is that spending tends to drop after one retires (and then rebound a bit later in life, according to a study by Morningstar head of retirement research David Blanchett). But there’s also a wide variation around the norm (spending generally drops off less for wealthier retirees, for example). So depending on the particulars of your situation, you could end up spending less, the same or more than you did before you retired, or even more.
So how do you deal with such ambiguity? My recommendation is that unless you have a really compelling reason to believe otherwise, you should save during your career as if you’ll need at least 80% of your pre-retirement income when you retire. Shooting for less requires less saving. But if you underestimate the amount you’ll need and turn out to be wrong, you’ll have to downscale your standard of living, which isn’t an adjustment most people like to make. Once you’re within 10 to 15 years of retirement, you can then start doing an actual retirement budget. An online budget worksheet like the one in Fidelity’s Retirement Income Planner tool can help you get a good handle on the expenses you’ll face, and you can update your estimates as you near and enter retirement. There will always be unexpected expenses and surprises. But you’ll be better prepared to handle them if you do some serious thinking about your retirement spending before you leave your job.
3. Smart investing can make up for anemic saving. There’s a temptation to think that we can compensate for a weak savings effort by shooting for higher investment returns. But that’s wishful thinking. Sure, earning 8% a year for 40 years instead of, say, 7%, will give you an extra $295,000 at retirement, assuming you start out earning $40,000 a year, get 2% annual raises and contribute 10% of salary until you’re 65. But higher returns aren’t just something you can plug into a spreadsheet and then expect to materialize. Other than focusing on low-fee investments, the only way to boost returns is to take more risk, and that makes your retirement accounts more vulnerable to market downdrafts. What’s more, if your high-risk strategy backfires, you could even end up worse in the long-run than had you followed a less aggressive one.
A better approach: Save at an adequate rate so you can set an investing strategy that jibes with your risk tolerance and that makes sense given the forecasts for low rates of return in the years ahead. That doesn’t mean you can’t take prudent risks. During most of your career when growing your nest egg is important, you’ll probably want to devote most of your savings to stocks. But as you get closer to and enter retirement, you become more concerned about preserving the savings you’ve accumulated, so you’ll likely want to scale back on equities. For a guide to reasonable stock-bond allocations, you can check out the Vanguard target-date retirement funds for someone your age. Bottom line, though, is that saving (and once you’re in retirement, spending) drives retirement success, not investing.
4. You won’t outlive your savings if you follow the 4% rule. Back when the stock market was generating long-term annualized returns of 10% or so, this rule worked, kind of. It didn’t guarantee your money would last at least 30 years in retirement, but the success rate for people who followed it were high, say, 90% or so. But with investment pros like Portfolio Solutions’ Rick Ferri forecasting far lower returns for stocks and bonds in the years ahead, that success rate has declined a good 10 percentage points or more. As a result, some experts suggest that an initial withdrawal of 3%, or even less, is more appropriate in today’s market.
But there’s another problem with the 4% (or even 3%) rule that doesn’t get as much attention. Even if you succeed in not running out of money, following it could leave you with a big stash of cash late in retirement if the markets do well. Not a problem, you say? Well, that extra cash is money that you might have enjoyed earlier in life if you hadn’t been restricting your withdrawals.
I recommend you start your retirement with a reasonable withdrawal rate—say, 3% to 4% if you want your nest egg to last 30 or more years—and then monitor how you’re doing by plugging your savings balances and projected spending into a retirement income calculator that uses Monte Carlo simulations to assess how long your nest egg might last. You can then make small ongoing adjustments as needed, perhaps cutting back on withdrawals if your nest egg’s value has plunged or loosening the purse strings if a booming market has boosted the balance of your retirement accounts.
In short, when it comes withdrawals, as well as the other three tenets cited above, a rule of thumb may be a decent starting point, but you’ll have to exercise some creativity, flexibility and common sense to get you the rest of the way.
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