We all like rules of thumb. They promise to simplify our lives. For instance, we’ve all probably heard the saying “Red sky at night, shepherds’ delight; red sky at morning, shepherds’ warning”. That’s a traditional rule of thumb for weather forecasting. Unfortunately, its accuracy is rather less good than the forecasts by the met office’s supercomputers analysing data from weather satellites!
Similarly, there are various rules of thumb for retirement planning that are doing the rounds. In this article, I’ll mention some of the most popular ones.
Target a multiple of your salary
I’ll start with one of the most sophisticated of the rules of thumb I’ve seen so far. It was put forward by Fidelity Investments. The rule is that by the time you reach a certain milestone age, you are expected to have saved a target multiple of your salary. The idea is to have saved enough to maintain your pre-retirement lifestyle after retirement.
I’ve seen two different variants published by Fidelity. Here’s the first variant, showing the target savings by milestone age:
- 35: 1 times salary.
- 40: 2 times salary.
- 45: 3 times salary.
- 50: 4 times salary.
- 55: 5 times salary.
- 67: 8 times salary.
Here’s the second variant:
- 30: 1 times salary.
- 40: 3 times salary.
- 55: 7 times salary.
- 67: 10 times salary.
The multiples are actually meant to depend on your target retirement age. Both variants assumed a retirement age of 67. Earlier retirement would require higher multiples. Fidelity provide an online tool that can assist with these adjustments.
It’s fair to say that if you followed either variant of these rules, you’d be making progress in your retirement planning. However, like all rules of thumb, it’s an approximation. Depending on your personal circumstances, and on uncertain investment returns, it might be over-saving; or it might be under-saving.
Also, you still need to analyse your cash flow, so as to set aside savings to meet the targets. Having said that, I would rate this as one of the better rules of thumb. Using such a rule provides more structure than having no framework at all.
Investments double every decade
Maybe this is not strictly a retirement rule of thumb, more of an investment one. But because it’s a long-term rule, it’s sometimes cited in the context of retirement planning.
The rule says that, on average, investments double in value every ten years. So, let’s say you’ve invested £50,000 by the time you’re 30. Then by the time you’re 60 that investment will have doubled 3 times. That’s 2 x 2 x 2. That means it will have multiplied in value by 8 and become £400,000.
Let’s say you manage to save an additional £50,000 each subsequent decade until you’re 60. Then the second £50,000 will be multiplied by 4, the third by 2, and the last by 1. The total saved at age 60 would then be £750,000.
The problem is, it’s not really a rule, but an illustration of the power of compounding. It assumes that investment growth averages at 7% per annum. This may well be a reasonable average for relatively high-risk investments. However, it doesn’t take into account the real possibility of under-shooting the doubling target. It also doesn’t cater for risk aversion.
Perhaps worst of all, it completely ignores inflation. After 30 years, £750,000 will have much reduced spending power compared with today. If inflation were to average 3% a year, £750,000 would only be worth around £300,000 in today’s money.
For me, the doubling ‘rule’ is one of the least useful rules of thumb.
Save a fixed percentage of your salary
This is one of the simplest rules of thumb. It suggests saving at least 10% of your salary.
The simplistic version suggests saving exactly 10% of your salary. However this ignores the age at which you start saving. If you wait till you’re 50, then 10% may be too low.
The question then becomes, what percentage should you choose? This begins to show the weakness of this rule. Its biggest problem is that there’s no goal involved. You may have a sense of how much to save, but not how much to spend – whether before or after retirement. Why is one savings percentage better than another?
There are numerous drawbacks with following this rule. However, it provides more structure than not saving at all.
Save a percentage of salary equal to half your age
This is a more sensible variant on the previous rule. It suggests saving a percentage of salary equal to half your age. So if you’re 20, save 10%. If you’re 40, save 20%. And so on.
The thing I quite like about this rule is that it tends to even out spending somewhat over your working life. Economists call this ‘consumption smoothing’. The idea is that most people would prefer to maintain a constant standard of living both before and after retirement. Your salary is likely to increase as you get older, thus giving you more money to spend, should you choose. However, by saving a bigger percentage of your salary, this can offset the effect and may lead to lower spending than otherwise.
This rule doesn’t result in precise consumption smoothing, but it moves in that direction.
Your percentage of bonds should equal your age
This rule says that the percentage of bonds in your retirement portfolio is set equal to your age. There are some implied assumptions behind this rule:
- The rest of your portfolio is made up of shares.
- Bonds are less risky than shares.
- The older you are, the less risky your portfolio should be.
- You start de-risking your portfolio early.
All of these assumptions are debatable:
- There are other asset classes besides shares and bonds: there are cash and property, to mention just two.
- If interest rates are on a rising trend, bonds could be riskier than shares, unless the strategy is to hold them to maturity.
- Many commentators support this idea. However, some have argued that it can be better to de-risk leading up to retirement, and then increase risk again afterwards.
- Starting to de-risk too early (e.g. in your 20s or 30s) could mean that you miss out on potential long-term growth.
The 80% rule
This rule says that, after retirement, it suggests replacing 80% of pre-retirement pre-tax income. Of course, if you start saving late, you’ll have no chance of achieving 80% income replacement. So that limits its usefulness from the start.
You might want to check out an article I wrote about this rule a couple of years ago. My conclusion then, which is unchanged now, was that it was not very useful.
The 4% rule
Finally we come to what’s perhaps the most famous of the retirement rules of thumb. It proposes withdrawing 4% of your retirement portfolio in the first year. You can then adjust your withdrawal amount each subsequent year by inflation.
As a first guess, the 4% rule is not too bad. However it ignores numerous factors, which I covered in a previous article.
Escape from rules of thumb
You might get the impression that I’m against rules of thumb. Actually, I think some of them are useful, provided you don’t take them too seriously, and you understand their limitations.
When I came up with the idea of the EvolveMyRetirement® Intelligent Financial Planning Calculator, I wanted to do better than following rules of thumb. It provides a structured way to explore retirement planning.