As I said in my previous article, we at Sensible Financial are not big fans of financial rules of thumb. Every situation is different and demands careful analysis and critical thinking. One-size-fits-all rules of thumb may be helpful to some, but they can be poor advice for many others.
My first Rules of Thumb article focused on saving and accumulation. This is part 2, geared more toward retirement and withdrawals.
“Let’s assume that people live in retirement on 80% of what they are used to.”
This took hold several decades ago as a rough estimate, and we find it to be too rough. It tries to capture the notion that retirees do not have mortgage or retirement savings “costs” like they did when earning. Therefore, they can live on less than they used to.
This rule of thumb might only work for people whose retirement coincides with paying off their mortgage. For those who paid it off years ahead of retirement, or who carry one into retirement, this assumption does not match their actual cash flow. The rule of thumb would indicate that they reduce their lifestyle, which is a bold assumption. Although spending composition may change over time, not many people are keen to reduce their lifestyle in retirement, and in fact, many wish to spend more in the early years of retirement on things like travel.
Permanent life insurance as a good way to build wealth
Too many people have been sold various forms of permanent life insurance that are not suitable. Salesmen often say something like “this policy will build cash value that will provide a fantastic nest egg for retirement.” Unfortunately, it is an incredibly expensive and inefficient way to invest and build wealth.
With these policies, some premium dollars go toward building the cash value. In other words, each premium payment partially pays for life insurance and is partially for investment, with the insurance company doing the investing for you. Those insurance expenses eat into the investment returns, often resulting in slow growth. In addition, the cost to invest—either by way of fund or insurance company fees—can range from 1-2%. Far greater than a simple index fund that charges 0.08%, for example.
We suggest not combining your investment and insurance needs; it’s better to tackle separately. It is often best to buy term life insurance to protect loved ones, and it is less expensive to invest without the “help” of an insurance company.
The 4% safe withdrawal rule
In the 1990s, advisor William Bengen came up with this guideline: that one can draw 4% in year one of retirement (then increase with inflation as time goes on). Although there is some truth to this, it should only be used as an initial guideline. It is by no means right for everyone, and more specific analysis and planning is required.
First, some people can spend more than this but restrain themselves. Some may do so specifically to support the next generation (or a family member in need), while others simply may not be spending as much as they could and might wish to.
Second, this rule does not fully take into account that drawing from your portfolio as a newly retired 65-year-old is much different than drawing as a 90-year-old. Adverse effects, like high inflation and/or poor market returns, can be especially devastating for those in early retirement. In addition, the degree to which these things damage the portfolio depends on how the portfolio was constructed. For example, a portfolio with inflation-protected bonds would support one’s retirement much more robustly through high inflation years than a portfolio with nominal bonds.
These are three rules of thumb often heard. They can serve as a starting point, but should be taken with a grain of salt. Your situation demands deeper thought and analysis, as everyone’s situation is different. If you have questions, please feel free to contact your advisor.
Photo by Brendan Church on Unsplash