I have a love-hate relationship with financial rules of thumb. On one hand, I recognize that not everyone is going to spend as much time thinking about and researching financial topics as they should, and rules of thumb give them easy-to-remember guidelines for staying on track. But on the other hand, these types of guidelines are often inaccurate, outdated, or outright wrong—and following them can derail the very goals you're trying to achieve.
This post originally appeared on Moneyning.
In particular, saving for retirement seems to be a subject that attracts these "rules." What's worse is that these rules will often still be stated as facts long after they've lost credibility.
Here are three retirement rules that no longer apply, followed by what you should be doing instead.
Retire with $1 million to live comfortably
This rule of thumb has a lot going for it: $1 million makes for a nice, round number to aim for, and it sounds like plenty of money to live on.
Unfortunately, there's also plenty wrong with this guideline. The first is the fact that $1 million isn't quite the huge sum it once was (as Dr. Evil found out, much to his chagrin). Depending on where you live in retirement and what lifestyle you lead, you may find that $1 million won't ensure 25 to 30 years of comfort.
And even though $1 million isn't a huge amount of money anymore, it is still out of reach for many Americans. According to Certified Financial Planner Mickey Cargile:
Less than 5 percent of our population has $1 million.
For the 95% who don't, the sum is so intimidating that it makes some people give up on saving altogether.
The Better Rule: Plan on having 8x your final salary
While this rule doesn't have an easy number to remember, it's a much better and more personalized metric for determining what you'll need for a comfortable retirement.
Saving 8x your ending salary is a reasonable goal for any worker. The objective is to replace 85% of your final income in retirement (see the rule of thumb below), with one year's salary saved by age 35, three years' salary by age 45, and five years' salary by age 55.
You'll need to replace 80% of your final salary in retirement
This rule of thumb isn't necessarily bad or outdated advice — it's simply too general to truly help you figure out what your retirement income needs to be. That's because how much you need depends entirely on your retirement activities. If you plan to travel the world in retirement, you'll need far more income than if you plan to become the world's foremost expert on daytime television. In addition, if your health deteriorates, you'll need more retirement income than you would if you stay healthy as a horse in your golden years.
The Better Rule: Decide what your retirement lifestyle will be
The original rule ignores the fact that there are many variables for every retiree — everything from the cost of living to health needs to leisure activities. So it makes more sense to actually take the time to dream about what you want to do in retirement (which is a heck of a lot more fun than calculating what 80% of your salary is), and figure out how much that lifestyle will cost.
Use the 4% rule to draw on your retirement income
On the surface, this rule seems to make great sense. If you withdraw no more than 4% from your nest egg each year, you'll protect your principal, ensuring that your money lasts your entire lifetime.
This is absolutely true — when the market is doing well. However, withdrawing 4% of your nest egg will wreak havoc on your account if the market is trending down. This will leave you in the unenviable position of either living on less that year, or taking the 4% and having it negatively affect your finances for several years.
The Better Rule: Use the bucket method to protect your nest egg while you live on it
Even if you do follow the 4% rule of thumb, it's an excellent idea to keep some of your nest egg in longer-term investments (a long-term bucket, so to speak) that you don't touch for the first decade or two of your retirement. Doing so allows you to have investments, say cash in an online savings account, that will ride out market volatility, while still having assets that keeps growing maintaining your quality of life in tougher years.
The Bottom Line
Rules of thumb are helpful for making sure you plan for retirement, even while you're busy living your life. It's important, however, to remember that these guidelines aren't going to be true for every person in every situation. Make sure you're following the guidelines that work best for you.
Photos by Kim Love, John Spade & 401(K) 2012.
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