Why These Three
of Thumb are Bad Ideas
all looking for simple rules of thumb to help our retirement
planning. But three popular ones - 3% savings, 4% drawdown, 120%
minus your age – may be dangerous to your retirement health.
What makes a good rule of thumb? It should be memorable, pithy and,
above all, useful. It also shouldn’t overreach; it just gives good
guidance. "Measure twice, cut once" is a great example. It doesn’t
try to explain carpentry. It just reminds us to take our time, be
precise and avoid making a mistake that can’t be undone. (Not bad
for four words.)
What makes a bad rule of thumb? How about this: it doesn’t work. Or
worse, it brings about exactly the opposite of what you intended.
Retirement is full of advice that sound reasonable but may be bad
for your retirement health. Here are three to be wary of:
of Thumb #1: Save 3% of Salary for Retirement
The most frequent auto-deferral rate into a 401(k) is 3% of pay,
probably because it typically maxes out the company match.
Unfortunately, 3% is just not going to get the job done.
Think of it this way: you will likely work for about 40 years and
retirement can last up to 30. That means 40 years of pay checks need
to be spread across 70 years. Common sense suggests that 3% (even
with a company match) is not going to be enough provide the spending
you’d like once you’re in retirement.
Our recent research suggests that 10 to 13% is more reasonable. 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.
of Thumb #2: The 4% Drawdown
Let’s say you retire with one million dollars in savings. One of the
most common rules of thumb is that the first year you should
withdraw 4%, or $40,000. Next year, add a cost of living adjustment,
say 2.5%, and take out $41,000. And so on.
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. If the market rallies, the opposite can happen
and you will leave behind a large unspent surplus. (Great for your
heirs, of course, but you would have enjoyed retirement less than
you could have.)
So what’s a better rule of thumb? Probably one based on a dynamic
amount, 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. What’s more, as you get older and
have a shorter retirement period to fund, you can increase the
of Thumb #3: 120 minus Your Age
We know that it makes sense to have a more conservative portfolio as
you get older. This Rule says the equity percentage in your
portfolio should be 120%, minus your current age. So a 60 year old
should have 60% equity while a 75 year old should have 45%. We can
quibble over the percentage, but this sounds reasonable, right?
Well, no. And here’s why. Let’s say the 60 year old is retired and
the 70 year old is healthy, happy, still working and plans on
working until 75. The 70 year old can actually tolerate more risk
than the 60 year old because she has five years of future wages to
grow her assets and offset market loses. The 60 year old has no more
future wages to offset losses and may feel that 60% equity is too
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.
As always, we are available for any questions or concerns you may
have. So feel free to call or email us at 925-757-6018 or send me an
Juan Pablo Blanco, Gina Castaneda and the Rest of the
Smeed Financial Team
201 Sand Creek Rd. Ste. E
Brentwood, CA 94513