3 Bad Rules of Thumb for Retirement Savings

June 2, 2014
Laura Joszt

Most people fall back on "rules of thumb" in order to plan for retirement, but 3 popular ones could actually be bad for your retirement health.

Retirement can be so difficult to plan for that most people fall back on “rules of thumb” in order to plan for one of the most uncertain times in their lives. These rules are supposed to give workers a general idea of the best way to save, spend, and grow their money to make living on a fixed income possible for as long as they live.

Most of these rules of thumb became such because they are useful, but also because they are easy to remember, as Chip Castille, head of BlackRock’s US Retirement Group and managing director of the BlackRock Blog, pointed out.

However, just because something survived to be known as a rule of thumb, doesn’t make it a good one to follow. In fact, some don’t actually work, or may bring out the opposite of what you are intending, according to Castille.

He highlighted 3 popular rules of thumb that could be bad for your retirement health:

Save 3% of salary for retirement

Why it’s bad: Not enough to get the job done

There’s a reason why so many Americans are behind on their retirement savings—even high-income earners like physicians are facing a shortfall. Castille conjectured that 3% is the rule of thumb because it’s an amount that typically maxes out the company match. However, just meeting the company match is not enough. People should be maxing out all the contributions they can make to multiple accounts if they want to save enough for retirement.

“Our recent research suggests that 10 to 13% is more reasonable,” Castille wrote. “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.”

A report from Fidelity Investments suggested physicians, in particular, should be saving 15% or higher to continue living the lifestyle they are accustomed to.

The 4% withdrawal rate

Why it’s bad: The formula is too rigid

The 4% withdrawal rate was considered a safe rate when it was proposed—20 years ago. The idea was to withdraw 4% in the first year, and thereafter increase that initial amount by the inflation rate.

So, as Castille explained, someone with a million-dollar savings account would withdraw $40,000 the first year. Say inflation was 2.5%, then in the second year the retiree would withdraw $41,000 total.

“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,” he wrote.

If the market is strong, then the retiree could leave behind a large sum of money that he or she could have enjoyed during retirement. At the very least, that money will go into the estate (and be taxed) for heirs.

Castille suggested forgetting the 4% rule and basing the withdrawal amount on 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,” according to Castille. “What’s more, as you get older and have a shorter retirement period to fund, you can increase the percentage.”

120% minus your age

Why it’s bad: Working years is more important

Most people know to have a more conservative portfolio as they get older. The closer to retirement, the less time a worker has to recover money lost in market downturn. The 120% rule recommends that the percentage of equity in a portfolio should be 120% minus the investor’s age. Therefore, a 60-year-old would have 60% equity, while a 70-year-old would have 50%.

However, Castille explained that the 60-year-old and 70-year-old could be in very different working situations. Someone who retired unexpectedly at age 60 might feel like 60% equity is too much risk. Whereas a health 70-year-old who plans to work another 5 years can tolerate more risk than someone a decade younger because he or she has future wages to offset market losses.

“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,” he wrote.