Using Rules For Retirement Planning

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Using Rules For Retirement Planning

Personal finance uses shorthand for a lot of different concepts. This shorthand allows people to make decent financial decisions without having to understand the underlying fundamentals. The 4% Rule is one example. So is having a year’s worth of living expenses in cash or cash equivalents in retirement, and the idea that you should be able to generate 80% of your pre-retirement income–via investments, Social Security, pensions, or other sources–in order to retire comfortably. (This is known as the Replacement Ratio.) 

Another Big One: The Rule Of 100.

Simply put, it says that, to figure out what your big-picture asset allocation should look like, subtract your age from 100, and put that percentage of your assets in stocks, with the remainder in fixed income. If your age is 65, subtract 65 from 100, meaning you’d want 35% of your assets in stocks, and 65% in bonds.

Anybody following this advice recently might be wondering if the world had been turned upside-down. The price of the 30-year Treasury bond is down more than 40% from its August 2020 peak, and most other fixed-income investments are way down as well. That’s not exactly what proponents of the Rule of 100 had in mind.

The general rule–reduce your risk exposure as you get older–still applies. But what does it really mean? It turns out there are a number of ways to put that concept into action.

A Rule Evolves 

There’s nothing wrong with shorthand. But it should not be considered settled law, and it should be questioned periodically.

In the case of the Rule of 100, one thing to consider is how life expectancy has changed. That is, it has risen since the rule was first created. So making 100 more like 105, 110, or even 120 probably makes sense.

But there are other things to think about here too, as those riding out bonds’ collapse know well. The rule should not be a starting point, but rather an ending point. Asking a few questions first could help you determine whether the rule makes sense for you.

Spending And Income

We mentioned another rule earlier having to do with spending in retirement. That rule–the ability to generate 80% of pre-retirement income–is also very much a moving target. But it leads to a very important question: What do you plan to spend in retirement?

This question needs to be answered before determining whether the Rule of 100 applies in your case. To use an extreme example, say your spending needs in retirement are modest relative to your income-producing assets (investments) and other vehicles (pensions or Social Security). Maybe you are 65, plan to spend $75,000 a year, have $25,000 in Social Security benefits, and a $2 million portfolio.

In this example, the rule is basically moot. You’ll get a third of your spending needs covered right off the top–and Social Security is more or less indexed to inflation. Meanwhile, if you put your entire portfolio into Treasury Inflation Protected Bonds (TIPS), you won’t need to worry about inflation at all. (Inflation can really wreck a retirement plan.) You won’t have any capital appreciation to speak of, but your portfolio also won’t effectively be losing value the way it would if you were in cash. You could just draw down $50,000 a year–and have some breathing room for unexpected expenses–for the rest of your life. 

Figuring these types of retirement planning issues out is not easy to do in your head or even in a spreadsheet. That’s why it is important to have a retirement plan created by a reputable financial planner or to use DIY comprehensive retirement planning software, such as the WealthTrace Retirement Planner. This way you will know exactly what you are dealing with in terms of your retirement and you can make changes before it’s too late.

Risk Tolerance

Bond investors have had a rough time of it in recent months, as we mentioned. The good news is that bond yields are now starting to look attractive again. 10-year government bonds, paying 3.9% or so currently, aren’t keeping up with inflation, but should eventually beat it once things settle down again.

Which brings us to our next question: What is your tolerance for risk?

We are not referring to your willingness to drive 90 miles an hour without a seatbelt. We mostly mean your tolerance for market volatility. 

If you’re invested in the equity markets right now, you know what we’re talking about. Fears of inflation and an imminent recession have driven stocks lower across the board. So if you’re headed for retirement soon, consider this a dress rehearsal. How have you reacted to the market turmoil? Does your portfolio’s performance literally keep you up at night? (If you’re not headed for retirement anytime soon, try not to pay attention to financial news, and just keep saving and investing on a regular basis.)

A lot of retirees like to supplement their income with dividends. But this generally means breaking the Rule of 100. If you’re 70 years old, the rule would say you should only have 30% of your assets in stocks.

Now, you can choose to invest in equities that are on the conservative end of the risk scale: large-cap companies that have paid consistent, and even growing, dividends for decades. If you go this route, your yields will be in the 4% range. One popular dividend-oriented ETF, Schwab US Dividend ETF, ticker SCHD, holds a market-capitalization-weighted portfolio of about 100 large company stocks that pay dividends. It currently yields around 3.8%.

If you have a $1 million portfolio, the rule would say to put $300,000 of it in the stock market. But that would only generate around $11,000 annually invested in SCHD. Unless you have other large sources of income to cover expenses, you would need to either break the rule (by upping that $300K) or get more aggressive with the stock portion of the portfolio and hope for the best.

Know The Rules, But Don’t Always Follow Them

The problem for the risk averse, especially in recent years when bond yields have been so paltry, is that they have had to be in the stock market. The acronym TINA–for There Is No Alternative–became popular in expressing that you really had no choice if you wanted capital appreciation and income generation.

With bond yields on the rise, we’re getting back to a place where there is an alternative again. Even so, you might have to bend or break the Rule of 100 to get you the income you need.