Debunking Financial Myths Part 6, Following the “Rules of Thumb”
“Rules of Thumb” can be helpful tools when planning and making decisions about your financial future. Applying any such rule strictly, however, can provide a false sense of security and could be downright dangerous. Let’s take a look at two otherwise helpful rules:
“The ‘4% Safe Withdrawal Rate’ assures you won‘t run out of money.”
False. The “4% Withdrawal Rate” is intended as a general framework for how much income can be drawn from an investment portfolio each year during retirement. While limiting withdrawals to no more than 4% of the portfolio’s value each year can help sustain a portfolio and the income drawn from it, applying the 4% rule does not provide any guarantee of lifetime income. With a $100,000 portfolio, for example, the withdrawal amount would be $4,000 a year. If a stock market correction caused the portfolio to fall in value to $80,000, the annual withdrawal would decline to $3,200. And, that $3,200 would be harvested from investments that have lost 20% of their value; more shares of the portfolio would have to be liquidated at an inopportune time.
“The ‘Rule of 100’ is a simple and precise way of determining how much of your money should be at risk and how much should be protected.”
False. The “Rule of 100” is an attempt to accomplish stability of principal and reduction of risk. The older someone is, the less time they have before they will need to draw retirement income and the less time they have to recover from investment losses. To follow the “rule,” subtract your age from 100 to calculate the percentage of your overall portfolio that you could allocate to more risky investments. A 40-year-old would have 60% at risk and 40% not at risk while a 70-year-old would have just 30% at risk. Relying exclusively on age to determine your risk level, however, can create two major problems: 1. the “rule of 100” does not factor in your personal tolerance for risk; 2. it also fails to consider longevity; a person whose family members live into their 90s needs to plan differently than the person whose ancestors never lived past 70.
Rules of thumb can’t assure financial success, but they can be used as a starting point. Your individual plan for retirement, however, needs to consider personal preferences and circumstances, and should be customized accordingly.