Five retirement planning rules-of-thumb that don’t work, and several that do

If you’re like many people, you might see that retirement is creeping up on you. If so, you may be wondering how you should set up your retirement income. Maybe you’ve talked about it with some friends and asked for their opinions, and read about it on the internet. Perhaps you’ve also spoken with a financial advisor.

These are things many people do when they begin exploring their financial future. The question is, are you actually getting good advice?
 
When it comes to retirement income, most financial advisors rely on a few rules of thumb that have been handed down from one generation of advisors to the next. The rules appear to be based on common sense, and many people will accept them without question.
 
But . . . do these rules of thumb actually work?
 
To find out, I tested them with 150 years’ history of stocks, bonds and inflation to see if they were reliable for a typical 30-year retirement plan today. Note that the average retirement age is 62, and that for half of couples that reach their 60s, one of them will live until age 94.
 
Below, I outline these five rules, the conventional wisdom that’s typically given to seniors. As you’ll learn, NONE of these rules is reliable based on history.
 
Rule 1: The “4% Rule” states that you can safely withdraw four percent of your investments and increase it by inflation for the rest of your life. For example, $40,000 could be withdrawn per year from a $1 million portfolio.
 
Rule 2: The “Age Rule” says that your age is the percentage of bonds you should have. At age 70 for example, you should have 70% in bonds and 30% in stocks.
 
Rule 3: The “sequence of returns” says you should invest conservatively because you can’t
afford to take a loss. You can run out of money because of the “sequence of returns”. You can’t recover from investment losses early in your retirement.
 
Rule 4: This rule tells you not to touch your principal. Instead, try to live off the interest.
 
Rule 5:The cash buffer rule: This advises you to keep cash that’s equal to two years’ income to draw on when your investments are down.
 
NONE of these rules is reliable based on history.Let’s look at each of these rules, one at a time.
 
Rule 1.
 
Based on history, the 4% Rule was safe for equity-focused investors, but not for most seniors.
It worked only if you invested with a minimum of 50% in stocks, and was even safer with 70 to 100% in stocks. It’s best to avoid a success rate below 95% or 97%. They mean a one in 20 or one in 30 chance of running out of money during your retirement.
 
Most seniors, however, invest more conservatively than this, so the 4% Rule failed miserably for them. A “3% Rule” has been reliable historically, but it means you only get $30,000 per year plus inflation from a $1 million portfolio instead of $40,000 per year.
 
These results are counter-intuitive. The more you invest in stocks, the safer your retirement income would have been in history.
 
To understand this, you need to realize that stocks are risky short-term, but reliable in the long term. Bonds are reliable short-term, but risky in the long term. This is because bonds get killed by inflation or rising interest rates, and if either happens during your retirement, you can easily run out of money with bonds.
 
My advice: Replace the 4% Rule with a more effective “2.5% +.2% for every 10% in stocks Rule.” For example, with 10% in stocks, use a “2.7% Rule”. If you invest 70% to 100% in stocks, then the 4% Rule is safe.
 
Rule 2.
 
History shows that the Age Rule directly conflicts with the 4% Rule. Based on the Age Rule, a typical retirement that goes from age 62 to 92 would average almost 80% in bonds. Historically, the 4% Rule ran out of money 31% of the time with 80% in bonds.
 
My advice: The Age Rule works with a 3% Rule. Look, there is nothing wrong with investing conservatively with the Age Rule, but then reduce your retirement income to withdraw only 3% of your investments each year.
 
Rule 3.
 
The “sequence of returns” is not supported at all by history. Do you believe you can be confident in the stock market? Over the long term, history says yes but in the short or medium term, no.
 
Note that there have been several market crashes over the last 150 years, but the only time you would have run out of money because of a market crash would have been if you had retired in 1929.
 
Because of the “sequence of returns”, the typical advice is to invest more conservatively with more bonds. This, however, is not safer.
 
My advice: Invest within your risk tolerance, but don’t think that having more bonds will make your retirement safer. If you invest more in bonds, reduce your retirement to a reliable level of 2.5 to 3% withdrawal rate. Fixed income is lower income.
 
Rule 4.
 
If you don’t touch your principal, can you live off the interest? Not likely.
 
This rule of thumb completely ignores inflation. Over the course of a typical 30-year retirement, the cost of living triples. This means you effectively take a cut in your income every year. Over a 30-year retirement, your income has dropped to only a third of your income in the first year.
 
Ever hear seniors complaining about being on a fixed income? This is usually because they are trying to live off the interest.
 
My advice: Any reasonable retirement income plan needs to include consideration for inflation increases in most years.
 
Rule 5.
 
This rule seems to make some sense, because you can live off the cash when your investments are down, giving them time to recover. You can avoid selling when prices are low, right?


Well, in a word, no. History does not support the Cash Buffer at all. “No cash” has consistently been the safest. In fact, I’ve been unable to find even one example in which holding any amount of cash was safer than no cash. I found studies using global stocks and UK stocks with many different strategies of how to use the cash. But I couldn’t find a single example of a benefit of cash.
 
The drag on your returns from holding cash sometimes caused you to run out of money, but holding cash never protected you from running out of money. In addition, if you held cash, you died with a significantly smaller estate to pass on to your loved ones.
 
This might seem counterintuitive. But remember, retirement is long, generally about 30 years. Stocks usually recover from declines. Holding cash for 30 years means you lose out on a lot of income, plus the loss of purchasing power due to inflation.
 
My advice: Forget the cash buffer. Just choose your investment allocation and stick with it.
 
My new rules of thumb
 
I’ll leave you with these words of encouragement: You can have all 3 – Higher income, lower risk of running out of money and less tax by investing with a higher amount in equities. Go with the highest amount in equities that you can be comfortable. Most of our retired clients have a comfortable retirement and invest 100% in equities.
 
You can have a higher, tax-efficient and reliable income, if you can manage your income effectively or are working with a financial planner who knows how to manage it effectively.