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I have a complex view on financial rules of thumb. On one hand, I understand that not everyone has the time to dive deep into financial research, and these rules offer quick, memorable advice to help stay on track. On the other hand, these rules can often be inaccurate, outdated, or completely wrong, and following them can actually hinder the very objectives you're trying to achieve.
This article was originally published on Moneyning.
Specifically, retirement savings seems to be a topic that is often governed by these "rules." What’s even worse is that these rules continue to be repeated as truths long after they've become irrelevant.
Here are three outdated retirement rules and what you should be doing instead.
Retire with $1 million for a comfortable lifestyle
This guideline has some merit: $1 million is a simple, appealing target, and it seems like an ample amount to live on.
However, there's a lot wrong with this advice. For one, $1 million isn’t the substantial figure it used to be (as Dr. Evil discovered, to his dismay). Depending on your retirement location and desired lifestyle, $1 million might not be enough to sustain you comfortably for 25 to 30 years.
And although $1 million is no longer a large sum, it remains out of reach for many Americans. As Certified Financial Planner Mickey Cargile notes:
Less than 5 percent of our population has $1 million.
For the 95% who don't, the amount feels so daunting that it causes some individuals to abandon saving entirely.
A Better Approach: Aim to have 8x your final salary
Although this rule lacks a simple figure to remember, it's a far more effective and tailored way to determine what you'll actually need for a secure retirement.
Saving 8x your final salary is a practical goal for any employee. The aim is to replace 85% of your final income in retirement (see the guideline below), with one year’s salary saved by age 35, three years' salary by age 45, and five years' salary by age 55.
You’ll need to replace 80% of your final salary when you retire
This rule of thumb isn't inherently bad or outdated — it's just too vague to accurately determine your retirement income needs. That's because how much you need depends entirely on your retirement plans. If you envision traveling the globe in retirement, you'll need significantly more income than if you plan to become the leading authority on daytime television. Additionally, if your health declines, you'll require more retirement income than if you stay as healthy as a horse during your golden years.
A Better Rule: Define what your retirement lifestyle will look like
The original rule overlooks the fact that each retiree has unique factors to consider — from living expenses to health care to recreational activities. Therefore, it's more practical to actually take the time to envision what you want your retirement to look like (which is a lot more enjoyable than calculating 80% of your salary) and determine how much that lifestyle will cost.
Apply the 4% rule to manage your retirement withdrawals
On the surface, this rule appears to be a sound strategy. If you limit your withdrawals to no more than 4% of your nest egg each year, you'll protect your principal, ensuring that your funds last throughout your lifetime.
This is absolutely true — when the market is performing well. However, withdrawing 4% of your nest egg can cause significant problems if the market is on a downward trend. This leaves you in the difficult position of either reducing your withdrawals that year or taking the 4% and facing negative financial consequences for several years.
A Better Rule: Use the bucket strategy to protect your nest egg while drawing from it
Even if you stick to the 4% rule of thumb, it's wise to allocate a portion of your nest egg to longer-term investments (a long-term 'bucket', if you will) that you don’t tap into during the first decade or two of retirement. This strategy lets you maintain investments, like cash in an online savings account, that can weather market fluctuations, while still having assets growing to help maintain your lifestyle in more challenging years.
The Bottom Line
Rules of thumb are useful for ensuring you prepare for retirement, even while you're busy living your life. However, it's important to remember that these guidelines won't apply universally to every individual or situation. Make sure you're following the rules that best suit your unique circumstances.
Images by Kim Love, John Spade & 401(K) 2012.
