By Teresa Kuhn, JD, RFC
Living Wealthy Financial
There are NO mulligans in retirement planning
During my years working in finance, law, and insurance, nearly every piece of money advice (good and bad) has drifted across my desk. Everyone has an opinion about how to save money, retire comfortably, and achieve the somewhat elusive goal of lifetime financial growth with minimal risk.
The financial services industry, like many others, is rife with misinformation and “fake news.” It also has more than its share of self-serving posers whose only goals are to separate you from your cash.
Unfortunately, unlike fake news about a celebrity or politician, bad financial advice and information can create situations where people near retirement make costly mistakes with their money. Retirees and those about to retire are encouraged to “trust the experts.” They often do, sometimes with poor results.
Hitting rules of thumb with a hammer
In this article, I’d like to examine a few common financial planning rules of thumb and why they may not work for most people in the new economy.
While rules are intended to guide individuals toward financial security and retirement readiness, economic instability and unpredictability have rendered them nearly obsolete.
You’ve probably heard of the “10% rule” and the “20% rule.” These chestnuts suggest that individuals save 10% and 20% of their income to ensure future financial stability. However, in today’s economic reality, the inadequacies of using these two guidelines as cornerstones of a retirement plan are apparent.
Retirement experts and financial planners often tout “The 10% Rule.”
The 10% rule advises individuals to save 10% of their annual income for retirement. This rule is rooted in becoming a consistent and disciplined saver during your working years, or “accumulation phase.” The idea is that when you consistently contribute a portion of your income to your portfolio, compound interest and investment returns will give you enough money to live on in retirement. The 10% rule remains a go-to principle for many retirement planners.
Doubling down on the “20% Rule.”
The more ambitious 20% rule suggests by saving an even more significant portion of your income, 20%, you will be on your way to a more comfortable retirement. This approach is based on the notion that individuals can better weather economic fluctuations and unforeseen expenses by saving more money. The 20% Rule has provided a foundational framework for many years. But, like much of the other cash “wisdom,” we can’t seem to let go of, the 20% concept has lost much of its allure.
Another flaw. Failing to account for earnings discrepancies
None of the rules mentioned so far consider the changing dynamics of income growth throughout one’s career. For example, younger workers typically earn less at the start of their careers. They could find it challenging to set aside specific percentages of their income while struggling to meet their other financial commitments. Traditional personal finance rules fail to accommodate such variations in income growth.
Case Study: James’ Retirement Savings
Consider James, a 30-year-old who makes $1,000 a week. According to the 10% rule, he should be saving $100 (10% of his income) every week. If he follows this rule for the next 40 years and earns an average annual return of 6% on his investments, his retirement account will grow to approximately $1,148,472.
However, this amount may be insufficient in a volatile economic environment with uncontrolled inflation. If James adheres to the commonly recommended 4% withdrawal rate in retirement, he will have an annual income of around $45,939. This calculation does not factor in taxes and assumes a fixed rate of return, which might not accurately reflect real-world investment performance. That annual income would probably not be enough to meet his essential financial obligations, let alone allow him to enjoy his retirement.
Does the “4%” Spend-down rule make sense anymore?
Once you’ve saved your money, you’ll need to know exactly how much you can spend before you run out of cash. Enter the “4% spend-down rule, “offering what was once considered the ultimate withdrawal strategy for retirees. The 4% spend down guideline recommends that you withdraw no more than 4% of your initial retirement portfolio balance in the first year of retirement. Then, you’ll make subsequent withdrawals for inflation. This strategy aims to ensure that retirees don’t outlive their savings, allowing their investments to last throughout their retirement years.
While the 4% rule has been a popular guideline, it has faced criticism over the past few years, particularly as market volatility and inflationary cycles have run rampant. Inflation reduces the purchasing power of money over time. The exact amount of money buys fewer goods and services than it did when you first formulated your retirement plan. If retirees withdraw a fixed 4% each year, the impact of inflation will gradually erode their purchasing ability. This, in turn, leads to a more rapid depletion of their retirement savings.
Case study: How inflation makes the 4% rule untenable.
Cecil, a 70-year-old retiree with an initial portfolio balance of $ 1 million, decided to follow the 4% rule. Cecil withdrew 4% of his $1 million, or $40,000, on his advisor’s recommendation. However, when he withdrew his money, the official inflation rate was 3%, meaning Cecil’s cost of living had increased by that amount or more.
To maintain his standard of living, Cecil now needs $41,200 in the second year of retirement. If he decides to cut back on his expenses and continue to withdraw the same $40,000 the second year, he will likely experience a decline in his lifestyle. Cecil will face a difficult choice if inflation increases: reduce his expenses even more drastically or dip into other accounts to cover his bills. Tapping into savings earlier than he expected may cause Cecil to run out of money when he most needs it.
The Need for Adaptive Financial Planning
Given the potential pitfalls of relying on rules of thumb, you must adopt adaptive financial planning strategies beyond fixed withdrawal percentages. The impact of inflation, varying income levels throughout your career, and changing economic conditions underscore the importance of personalized financial plans built around your unique circumstances.
Creating a diversified investment portfolio, including cash-flowing businesses or other assets that have the potential to grow at a rate equal to or greater than inflation, is vital. You can still retire successfully, but only if you regularly reassess your money goals and risk tolerance and adjust your withdrawal strategies in response to economic shifts. This is where developing a relationship with professional financial advice can help you discover the critical components of a successful retirement blueprint.
In Conclusion
While the 10% rule, the 20% rule, and the 4% spend-down rule have served for years as foundational guidelines for retirement planning, they have numerous limitations in the New Economy. To ensure a secure financial future, individuals must adopt dynamic, flexible, and adaptive financial planning strategies such as my “Untaxable Wealth Plan.” This signature financial blueprint considers inflation, income fluctuations, and evolving economic conditions. When you choose an Untaxable Wealth Plan, you can navigate the complexities of modern finance and position yourself for a comfortable retirement that stands the test of time.
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