These Rules Weren't Meant For You
Imagine two people are getting onto Interstate 459 at the same time. One of them is driving a first generation 1991 Ford Explorer that is known to have rollover issues at higher speeds. The other driver has just driven off the lot with a brand new 2016 Corvette Z06 which is a world-class supercar. Do you expect the speed limit on Interstate 459 to be different for the two different cars?
Of course not! The speed limit is not determined by what is appropriate for each driver or type of vehicle. The speed limit is a government-set maximum speed designed to protect the general public from people who drive at speeds that put themselves and others in danger. The speed limit is what authorities believe to be the most reasonable in creating a safe environment for all. You could argue that the Explorer is a danger to others at 70 miles per hour, while the Corvette can maneuver safely at 100 miles per hour, but that argument wouldn’t benefit the Corvette driver if he were to be pulled over for speeding.
While the rules of the road are the same for everyone, the “rules” of retirement planning are not, but many people think they are. Many people hear financial rules of thumb and assume these rules apply to them. Unfortunately, they often don’t.
Here are six common misconceptions that don’t apply to you:
• The maximum I am allowed to contribute to my 401k is enough for retirement; that’s why the IRS has set a maximum.
Deferred retirement investment vehicles, like the 401k, provide tax incentives for Americans to save for retirement. The maximum contribution (currently $18,000) is set by the IRS to prevent people from reducing their taxable income even further. The higher your income, the more you need to be setting aside additional funds in other retirement savings vehicles.
• The amount my employer will match is the amount I need to contribute to my 401k.
Most employers who provide a retirement plan match a certain percentage of employees’ contributions to be competitive with other employers, enhance their employee’s long-term success and encourage employees to participate in the plan. Every employer’s retirement match amount is different. The match is not designed to tell you how much you need for retirement; it is simply the amount the company is willing to pitch in if you contribute to the plan.
• I should save 15% of every paycheck for retirement.
The amount you need to save for retirement cannot be determined by this old adage. This may be enough for some, but for most of us, times have changed. Most of us start working at a later age and thus start saving at a later age, giving up substantial compounding. Furthermore, advancements in medical care have extended life expectancies, which means you need to plan for living longer in retirement. And you can’t count on Social Security to make up the gap since the more money you make, the lower the percentage of your income it will replace.
• The percentage of bonds in my portfolio should equal my age.
It is true that people who are older tend to have more bonds, but that is based on a number of factors besides age. There is no single factor that should determine your appropriate bond allocation. Other factors like your income needs, remaining life expectancy, and your risk tolerance must be considered.
• I will withdraw four percent of my retirement funds per year because people who do so outlive their money 80% of the time.
This “Four Percent Rule” was developed in the early 90’s, and while everyone agrees it’s outdated today, I believe it was a bad rule from the start. The problem with this rule is that its inventor developed it assuming certain asset allocations, a decent rate of return, and a retirement period of 30 years, among other considerations. He also seems to have assumed that 80% was a good success rate. But I wouldn’t want my clients to run out of money 20% of the time! How much you can afford to withdraw and not outlive your money depends on what you’re invested in, how disciplined you are, how early you retire, and how long you will live.
• When I retire, I’ll be able to live on only 60 - 80% of my maximum pre-retirement income.
The idea behind this misconception is that you’ll need less money in retirement because all your debts will be paid off, you’ll have fewer expenses and lower taxes, and you’ll maintain the same lifestyle. But this is almost never true. People tend not to plan what they will actually do in retirement until it’s time to do it. At that point, they suddenly have a lot more time, so they spend more of it – and therefore, more money – on things they enjoy, like travel, hobbies, and grandchildren. And even if you do spend less on pleasure activities as you get older, it is very rare to avoid spending more with each passing year on healthcare. With constant improvements in medicine and related technology, it’s increasingly possible to live past average life expectancy, and the longer you live, the more money you’ll need.
With all that said, there is one general rule of thumb you should always pay attention to: it is wise to seek the guidance of an experienced professional with your retirement plans no matter what your stage of life. If you are still saving for retirement, a good financial advisor can help you take maximum advantage of the resources you have. And the closer you get to retirement, the more you need the counsel of a qualified advisor to help you develop a withdrawal strategy that’s appropriate for you.