Retirement planning has long relied on two guidelines, the 70 percent “replacement ratio” and 4 percent “withdrawal rate.” But no rule of thumb is good all the time, or for everyone, so how are these old rules holding up?
The replacement ratio is the percentage of one’s pre-retirement income required to maintain the same standard of living in retirement. It’s often been pegged at 70 percent.
“I personally believe this is an antiquated and archaic method of figuring income needs in retirement,” says Justin A. Goodbread, a planner with Heritage Investors in Knoxville, Tennessee, adding that 70 percent “is too low in the early years of retirement and about right in the later years of retirement.”
[See: 10 Costs You Can Eliminate in Retirement.]
Why not 100 percent? Because some expenses are likely to taper off in or near retirement. Children are likely to be grown and on their own, the mortgage paid off, commuting and work expenses like gas, a second car and lunches no longer as big. And, of course, a retiree will not be using a portion of income to save for retirement, and will withdraw from retirement investments rather than adding to them. If income falls, taxes will too.
That’s where the withdrawal rate comes in. It is the percentage of the retirement portfolio one can safely withdraw each year without depleting those savings too soon. Traditionally, this has involved taking out 4 percent of the nest egg in the first year, then increasing the dollar amount each year to offset inflation. If you took $1,000 a month in year one, you could take $1,030 in year two if inflation were 3 percent. Eventually, this would likely mean drawing on principal, not just each year’s interest earnings and investment gains, so that the fund would be empty after 30 or 40 years.
It’s pretty obvious that circumstances could upset these strategies. High inflation or a spike in medical expenses could force you to spend more than 70 percent of your pre-retirement income to maintain a comfortable lifestyle, and inflation or investment losses could drain your nest egg too early if you continued increasing that $1,000 in monthly income.
“The income replacement ratio can serve as a good starting point to formulate what the retirement needs may be,” says Steve Martin, an advisor with Oasis Wealth Planning Advisors in Nashville. But a sound plan takes a much deeper look at anticipated income and expenses, he says, noting that well-to-do retirees often live well on less than 70 percent of pre-retirement income, while people of lesser means need more than 70 percent.
As for the 4 percent withdrawal rate, that worked better when interest earnings were higher than today’s, says Robert Johnson, president and CEO of the American College of Financial Services in Bryn Mawr, Pennsylvania. “The current 10-year Treasury yield is only 2.22 percent, compared with an historical average of approximately 6.29 percent,” he says. “Current 10-year yields tell you the return you can expect over the next decade.”
That means you cannot rely on interest earnings alone for nest egg withdrawals.
[See: 10 Ways to Avoid the IRA Early Withdrawal Penalty.]
So how do you protect yourself in case things don’t go as planned?
Start with a budget rather than rules of thumb. Two people of the same age with comparable nest eggs could be in very different circumstances if one has a pension and the other doesn’t, one has a much longer life expectancy or a more lavish lifestyle. So it’s useful to start with a detailed list of current spending and a best guess of how each item might change, and other expenses that will be added, like supplementary Medicare insurance
“To me, the purpose of retirement income is to provide for a desired lifestyle,” says Ilene Davis, planner with Financial Independence Services in Cocoa, Florida, and author of “Wealthy by Choice: Choosing your way to a Wealthier Future.”
“It’s definitely a more complex task than just taking a percent (of pre-retirement income), but it is more personalized and based on needs rather than something that may be irrelevant. For example, I probably save 50 percent of my income each year. Someone else may save only 5 percent of their income. Using the same percent of pre-retirement income (as the replacement rate) would have me needing to save more than needed, and the other person saving less.”
Skimp in the early years. Downsize to a smaller home, unload the second car or move to a location where it’s cheaper to live. Enjoy cheaper activities while you are still healthy — biking, kayaking, entertaining at home instead of fancy restaurants. Reducing expenses in the early years will leave more money for later.
“If, for instance, someone retires and moves to a lower cost-of-living area and downsizes, the replacement income ratio can be much smaller,” Johnson says.
Have a fallback plan. If you don’t want to cut expenses at the start of retirement, think about how you could cut later. Maybe you don’t need to travel as much as you’d planned, or can visit national parks instead of touring Europe.
You also could maintain a reserve that isn’t part of the 4 percent calculation. That’s the same as taking less than 4 percent of the grand total but might be easier to stomach.
Working longer or returning to work are other options, though getting back into the workforce as a senior can be difficult. Working longer reduces the retirement years to fund, and allows investments more time to grow.
Invest more aggressively. Many target-date funds designed for retirement investments keep at least 50 percent of assets in stocks, even for investors in their 70s and 80s with the rest in bond funds of various maturities. True, there’s a risk of loss with stocks, but history shows they earn more than bonds or cash, and they’ve always recovered from downturns. A sizeable stock allocation could help you keep ahead of inflation, and there would be plenty of time to recover from a typical down market in a 30-year retirement.
[See: 10 Ways to Reduce the Cost of Retirement.]
Still, there’s obviously no guarantee your money will last as long as you do. Johnson notes that stocks are pretty expensive today relative to corporate earnings. “As a rule of thumb, I am much more comfortable with a withdrawal rate in the neighborhood of 3 percent annually,” he says.
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Is the Income Replacement Ratio Obsolete? originally appeared on usnews.com
